AS-Macro by xiaoyounan




This resource is designed as a complement to your studies in AS Economics and should not be regarded
as a substitute for taking effective notes in your lessons. Points raised and issues covered in class analysis
and discussion invariably go beyond the narrow confines of this guide. Economics being the subject that it is,
events and new economic policy debates will inevitably surface over the next twelve months that take you
into new and exciting territory. Providing you understand many of the core concepts and ideas available to
an economist, you will be in a good position to understand many of the new issues that arise and you will
build an awareness of the problems in developing strategies and policies to combat some the main
economic and social problems of our time.

Each chapter of this Guide contains a core set of notes, key definitions and diagrams together with a series
of short case study readings and web links designed to encourage you to read widely and explore many
aspects of the course in greater detail.

Economics is a dynamic subject, the issues change from day to day and there is a wealth of comment and
analysis in the broadsheet newspapers, magazines and journals that you can delve into. The more reading
you manage on the main issues of the day the wider will be your appreciation of the theory and practice of

Here are some resources on the Internet that you should make a point of visiting on a regular basis:

Web Resource                                Recommendation
BBC Business and Economics News             Incredible coverage of domestic and international issues
Economist                                   Leading international business magazine
Economist A-Z of Economics                  Useful background glossary with external links
Economist Country Briefings                 Series of short background briefings on all major economies
Ernst and Young Economic Update             Excellent quarterly research on the UK and global economy
Guardian                                    Great site for research and special reports – see their special
                                            archive section on economics using this link
Halifax Bank of Scotland Research           Excellent reviews on the UK economy
HM Treasury                                 The web site of the Treasury – superb for data
Independent                                 Strong coverage of current business/industrial trends
Institute for Fiscal Studies                Super resource for aspects of government fiscal policy
International Monetary Fund                 Excellent for global economic research and policy issues
Office of National Statistics               The main site if you need economic statistics for essays! The
                                            monthly Economic Trends is a superb resource for teachers
Organisation of Economic Co-operation       Superb for in depth analysis of the global economy from the
and Development                             OECD including country surveys and economic reports. For
                                            information on the UK use this link:
Royal Bank of Scotland                      Web site offering economic research on the UK and international
                                            economy including recent presentations
Tim Harford – Undercover Economist          Lively writing on economics each week – well worth it
Tutor2u Economics                           The leading AS and A Level economics portal! The daily
                                            economics blog is available here.


Table of Contents

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


    1. Introduction to Macroeconomics and Indicators of Economic Performance

In this chapter we consider what macroeconomics is and we look at some of the key indicators of interest to
students of macroeconomics.

What is macroeconomics?

Macroeconomics considers the economy as a whole and relationships between one country and
others for example we focus on changes in economic growth; inflation; unemployment and our trade
performance with other countries (i.e. the balance of payments). The scope of macroeconomics also
includes looking at the relative success or failure of government policies.

Introduction to the UK economy

      The City of London, an important centre for              The individual spending decisions of millions of
international finance and a major source of income for       consumers add up to affect the performance of the
                our balance of payments                                        whole economy

 Searching for work – unemployment has been low in             Anticipating demand – stocks of products in a
the UK for over ten years – but it is now starting to rise   warehouse. Businesses need to anticipate demand
                        again                                     changes when setting production levels

    •   The United Kingdom is one of the world’s leading advanced economies. It has the second largest
        economy in the European Union (EU) behind Germany and just ahead of France and it is the second
        biggest exporter of services in the global economy and ranked eighth in global exports of goods. In
        2006 the UK will contribute 3 per cent to global output.
    •   In terms of per capita national income, the UK is ranked in the top fifteen nations of the world and in
        2006 it is forecast that the UK will have a per capita income (PPP adjusted) of $31,529 some
        distance behind that of the United States and also Norway and Ireland, two of Europe’s richest


    •   Britain has enjoyed a period of continuous growth that stretches back to 1992, the longest sustained
        expansion for over forty years. However, in 2005, real GDP grew by 1.8%, the slowest pace of
        growth for twelve years.
    •   Over 27 per cent of the UK’s GDP in 2005 came from exports of goods and services. Imports
        amounted to 31.5 per cent of national income leading to a large trade deficit in goods and services
        with other countries.
    •   The UK joined the European Economic Community (now known as the EU) in January 1973 and it is
        a founder member of the World Trade Organisation. The UK retains its own currency having decided
        for the time being not to consider entry to the EU single currency area, the Euro Zone.

The main sectors of the economy

    •   Households: receive income for their services and then buy the output of firms (consumption)
    •   Firms: hire land labour and capital to produce goods and services for which they pay wages rent etc
        (income). Firms receive payment. Firms invest (I) in new producer goods
    •   Government: collect taxes (T) to fund spending on public services (G)
    •   International: The UK buy overseas products, imports, (M)) and overseas economic agents buy UK
        products, exports (X)

The world economy

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

European Union (25 countries)                                             NAFTA (3 countries)
Countries in italics joined in 2004                                       North American Free Trade Area
Germany                                  Greece                           United States
Austria                                  Czech Republic                   Canada
France                                   Poland                           Mexico
Italy                                    Slovenia
Netherlands                              Slovakia                         Other OECD (but non-EU)
Belgium                                  Latvia
Luxembourg                               Lithuania                        Norway
Ireland                                  Malta                            Switzerland
Finland                                  Cyprus                           Iceland
Portugal                                 Hungary                          Turkey
Spain                                    Estonia                          Australia
Sweden                                   Denmark                          New Zealand
                                         UK                               Japan
Emerging Markets include                                                  South Korea
India                               OPEC
Russia                              inc
Brazil                              Saudi Arabia
South Africa                        Nigeria
Targets and objectives of macroeconomic policy

Government management of the economy is a key political issue and each government sets targets and
objectives when it assumes power – and often, economic objectives and priorities lie right at the heart of a
government’s overall political strategy.

We focus on large number when we undertake the study of macroeconomics. For example, the value of
national output in the UK, expressed at constant prices so that we eliminate the effects of inflation on the
value of what we produce and consume, edged above £1 trillion in 2003. But we still stand well below the
United States, whose national output (GDP) accounts for over a quarter of world output each year. No
wonder that people often say “when the United States catches sneezes, the rest of the world catches a cold!”


What are the main indicators we use when making cross-country comparisons of economic performance?
Traditionally we have tended to focus on four key indicators of achievement. They are
    1. Growth: The rate of growth of real national output (i.e. real GDP)
    2. Inflation: The rate of price inflation (i.e. the annual percentage change in the price level)
    3. Unemployment: The rate of unemployment in the labour market
    4. Trade: The balance of payments in trade in goods and services and net flows of investment income
       – representing the effects of trade and investment between countries

The UK economic cycle

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











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

                          ar 4 quarters
                                                                                                 Source: Reuters EcoWin
The economic cycle is also known as the business cycle. The chart above shows the annual rate of growth
of national output for the UK economy since 1980. There have been two recessions in the last twenty-five
years. The early 1980s downturn was a deep recession – the worst downturn in the UK’s post-war history.
We can see the descent into recession in 1990 and 1991 and then a recovery which was maintained
throughout the remainder of the 1990s. Further positive rates of growth have been sustained in the first six
years of the current decade, allowing the UK economy to claim one of the longest periods of expansion in
our modern history. After a slowdown in 2005 the British economy looked to be enjoying stronger growth in
the first half of 2006.

As we shall see later, all countries go through a business or economic cycle leading to fluctuations in
national output and unemployment. The chart below shows what has happened to the US economy over
recent years.

The United States enjoyed a period of fast growth during the second half of the 1990s. But a combination of
rising interest rates (the US central bank raised the cost of borrowing to curb the growth of consumption) and
of course the fallout from the events of 9-11 which severely affected consumer and business confidence
brought about a sharp slowdown in their growth rate. The USA economy went into a steep slowdown – but
although, for a short period, national output did fall, the annual growth rate stayed positive before a recovery
emerged in 2002 and 2003. In 2003, the US economy grew by 3% and growth climbed above 4% in 2004
before edging lower in 2005. The United States has been running a policy of low interest rates for most of
the current decade. But between 2004 and 2006, they have been gradually increasing interest rates in a bid
to control demand and inflationary pressures. As a result, the speed of growth in the USA is now starting to


                                     USA Interest Rates and Real GDP Growth 1995-2005
                                                                                      Per cent

                 Percent                                                                               Interest Rates



                                Economic Growth
                               95         96         97          98          99         00           01         02         03         04         05

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

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


    2. Measuring National Income

We need information on how much spending, income and output is being created in an economy over a
period of time. National income data gives us this information as we see in this chapter.

Measuring national income

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

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

        2. Spending: i.e. the total amount of expenditure taking place in the economy.

        3. Incomes: i.e. the total income generated through production of goods and services.

What is National Income?

National income measures the money value of the flow of output of goods and services produced
within an economy over a period of time. Measuring the level and rate of growth of national income (Y) is
important to economists when they are considering:
    •   The rate of economic growth
    •   Changes over time to the average living standards of the population
    •   Changes over time to the distribution of income between different groups within the population
        (i.e. measuring the scale of income and wealth inequalities within society)

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

Gross Domestic Product

Gross Domestic Product (GDP) measures the value of output produced within the domestic boundaries of
the UK over a given time period. An important point is that our GDP includes the output of foreign owned
businesses that are located in the UK following foreign direct investment in the UK economy. The output of
motor vehicles produced at the giant Nissan car plant on Tyne and Wear and by the many foreign owned
restaurants and banks all contribute to the UK’s GDP.

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


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

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

Nissan at Sunderland – Celebrating 20 years of production

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

                                                           Sources: Reuters News, Sunderland Echo, July 2006

(i) The Expenditure Method of calculating GDP (aggregate demand)

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

                 C: Household spending
                 I: Capital Investment spending
                 G: Government spending
                 X: Exports of Goods and Services
                 M: Imports of Goods and Services

The Income Method of calculating GDP (the Sum of Factor Incomes)

Here GDP is the sum of the incomes earned through the production of goods and services. The main factor
incomes are as follows:

                 Income from people employment and in self-employment
                 Profits of private sector companies
                 Rent income from land
                 Gross Domestic product (by factor income)

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

We exclude from the accounts the following items:
    o   Transfer payments e.g. the state pension paid to retired people; income support paid to families on
        low incomes; the Jobseekers’ Allowance given to the unemployed and other forms of welfare
        assistance including child benefit and housing benefit.
    o   Private transfers of money from one individual to another.
    o   Income that is not registered with the Inland Revenue or Customs and Excise. Every year,
        billions of pounds worth of economic activity is not declared to the tax authorities. This is known as
        the shadow economy where goods and services are exchanged but the value of these transactions
        is hidden from the authorities and therefore does not show up in the official statistics!). It is
        impossible to be precise about the size of the shadow economy but some economists believe that
        between 8 – 15 per cent of national output and spending goes unrecorded by the official figures.

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

                                                                                                                                                                   - 10 -

This measure of GDP adds together the value of output produced by each of the productive sectors in the
economy using the concept of value added.

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

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

Index of Gross Value Added by selected industry for the UK

                                                                Mining and             Manufacturing            Construction           Distribution,         Business
                                                               quarrying, inc                                                          hotels, and          services and
                                                                 oil & gas                                                              catering;             finance
                                                                extraction                                                               repairs

2001 weights in total GDP                                                         28                 172                     57                     159             249
(out of 1000)
2001                                                                          100                    100                 100                        100             100
2002                                                                          100                     97                 104                        105             102
2003                                                                           94                     97                 109                        108             106
2004                                                                           87                     98                 113                        113             111

We can see from the following chart how there have been divergences in the growth achieved by the
manufacturing and the service sectors of the British economy. Indeed by the middle of 2006, the index of
manufacturing output was below the level achieved at the start of 2000.

In contrast the service industries have enjoyed strong growth, leading to a continued process of structural
change in the economy – away from traditional heavy industries towards service businesses.

                                                               Output of Manufacturing and Services
                                                                    Index of Value Added, Constant Prices, Seasonally Adjusted


        Index of output, 2002=100




                                    80                                             Services



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

                                               Gross, Service industries, Total          Gross, Manufacturing
                                                                                                                                       Source: Reuters EcoWin
GDP and GNP (Gross National Product)

                                                                                                          - 11 -

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

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

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

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

The figure for net property income for the UK is strongly positive meaning that our GNP is substantially
above the figure for GDP in a normal year. For other countries who have been net recipients of overseas
investment (a good example is Ireland) their GDP is higher than their GNP.

Measuring Real National Income

When we want to measure growth in the economy we have to adjust for the effects of inflation.
Real GDP measures the volume of output produced within the economy. An increase in real output means
that AD has risen faster than the rate of inflation and therefore the economy is experiencing positive growth.

Income per capita

Income per capita is a basic way of measuring the average standard of living for the inhabitants of a country.
The table below is taken from the latest edition of the OECD World Factbook and measures income per
head in a common currency for the year 2005, the data is adjusted for the effects of variations in living costs
between countries.

                                    GDP per capita $s                                       GDP per capita $s
Luxembourg                              57 704             EU (established 15 countries)        28 741
United States                           39 732             Germany                              28 605
Norway                                  38 765             Italy                                27 699
Ireland                                 35 767             Spain                                25 582
Switzerland                             33 678             Korea                                20 907
United Kingdom                          31 436             Czech Republic                       18 467
Canada                                  31 395             Hungary                              15 946
Australia                               31 231             Slovak Republic                      14 309
Sweden                                  30 361             Poland                               12 647
Japan                                   29 664             Mexico                               10 059
France                                  29 554             Turkey                                7 687

                                                      Source: OECD World Economic Factbook, 2006 edition

By international standards, the UK is a high-income country although we are not in the very top of the league
tables for per capita incomes. We do have an income per head that is about ten per cent higher than the
average for the 15 established EU countries. But we are some distance behind countries such as the United
States (where productivity is much higher). And Ireland’s super-charged growth over the last twenty years
means that she has now overtaken us in terms of income-based measures of standards of living.

                                                                                                           - 12 -

    3. Macroeconomic Objectives

All governments have targets and aims for the economy – in this chapter we consider the main objectives of
macroeconomic policy.

Objectives are the aims or goals of government policy whereas instruments are the means by which these
aims might be achieved and targets are often thought to be intermediate aims – linked closely in a
theoretical way to the final policy objective.

So for example, the government might want to achieve low inflation. The main instrument to achieve this
might be the use of interest rates (now set by the Bank of England) and a target might be the growth of
consumer credit or perhaps the exchange rate.

Only a limited number of policies can be used to achieve the government’s objectives. There is a huge
amount of research conducted in trying to determine the effectiveness of different policies in meeting key
objectives. Indeed the debates about which policies are most suitable lie at the heart of differences between
economic schools of thought.

The main policy instruments available to meet the objectives are
    •   Monetary policy –changes to interest rates, the supply of money and credit and changes to the
        exchange rate
    •   Fiscal policy – changes to government taxation, government spending and borrowing
    •   Supply-side policies designed to make markets work more efficiently
    •   Direct controls or regulation of particular markets

Find out more about schools of thought

If you want to delve a little deeper into the differences between schools of thought in Economics here are a
few links to resources available on the Wikipedia web site:

    •   Keynes and Keynesian Economists:
    •   Monetarists:                    
    •   Classical economists:           

The Objectives of UK Economic Policy

The Labour Government has several current macroeconomic objectives:
    o   Stable low inflation - the Government’s inflation target is 2.0% for the consumer price index. The
        Monetary Policy Committee sets interest rates at a level it thinks will meet the inflation target over a
        two year forecasting horizon. The Bank of England has been independent since May 1997 but
        inflation targets pre-date the decision to hand over control of monetary policy to the BoE. Inflation
        targets were first introduced into the UK in October 1992 and have played a role in keeping inflation
        expectations under control.
    o   Sustainable economic growth – as measured by the rate of growth of real gross domestic
        product – sustainable both in terms of maintaining low inflation and also in terms of the
        environmental impact of growth (for example the impact of growth on levels of pollution, household
        and industrial waste and the use and depletion of our scarce resources).
    o   Higher levels of capital investment and labour productivity – this is designed to improve the
        UK’s international competitiveness and boost our trade performance in goods and services. The
        pressures of globalisation and the increasing competition within the European Single Market make
        this one of the most important long-term objectives of the government. Britain needs to be
        competitive in an increasingly globalized world.
    o   High employment - the government wants to achieve full-employment – a situation where all
        those able and available to find work have the opportunity to work. But unemployment can never fall
        to zero since there will always be a degree of frictional and structural unemployment in the labour

                                                                                                          - 13 -

        market. At the time of writing, unemployment in the UK is at low levels, with less than three per cent
        of the labour force out of work and claiming the Jobseeker’s Allowance.
   o    Rising living standards and a fall in relative poverty – for example the objective of cutting child
        poverty and reducing pensioner poverty over the next few years – this will require a continuation of
        economic growth together with taxation and benefit changes to make the distribution of income more
    o   Sound government finances - including control over the size of government borrowing and the
        total national debt.

The Bank of England was made independent in May 1997 and has the job of setting interest rates as part of
 monetary policy. Interest rates are viewed as a key weapon in keeping control of demand and inflationary
   pressures in the economy. Most economists are in favour of Bank of England independence because
   economists are likely to make better judgements on interest rates than politicians seeking re-election!

The government always emphasizes macroeconomic stability as one of its main aims – it believes that the
stability of the economy is a pre-condition for improvements in capital investment, productivity, company
profits and employment.

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

                                                                                                         - 14 -

    4. Using Index Numbers

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

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

When we are measuring the level of national income we often make use of index numbers to track what is
happening to real GDP. In the table below we see the value of consumer spending and also real GDP
expressed in £ billion. I have chosen 1995 as the base year for our index of spending and output. So the
data for consumer spending and real GDP has an index value of 100.0 in 1995.

To calculate the index number for consumer spending in 1996 we use the following formula

Index (1996) = (consumer spending (1996) / base year consumer spending) x 100

                 Consumer spending            Index of consumer            Real GDP        Index of real GDP
                        £ billion                 1995 = 100                £ billion         1995 = 100
 1995 (Base)             512.6                       100.0                   857.5               100.0
        1996             531.9                       103.8                   880.9               102.7
        1997             551.1                       107.5                   908.7               106.0
        1998             572.3                       111.6                   938.1               109.4
        1999             598.8                       116.8                   966.6               112.7
        2000             625.1                       121.9                   1005.5              117.3
        2001             644.9                       125.8                   1027.9              119.9
        2002             667.4                       130.2                   1048.5              122.3
        2003             684.8                       133.6                   1074.9              125.3
        2004             710.2                       138.5                   1108.9              129.3

One of the advantages of index numbers is that it allows us to compare and contrast more easily different
sets of economic data. Consider the information in the table above. Using 1995 as our base year for the
index, we can see that consumer spending has grown more quickly than real national income over the period

Of course the two sets of data are closely linked because consumption accounts for more than 60% of GDP.
But the data indicates that consumer demand has been a key factor behind the continuing growth of the
economy, indeed consumption as a share of GDP has grown from 60% in 1995 to nearly 65% in 2003 – a
record level. Can this consumer boom continue? Much of it has been financed by high rates of borrowing
linked to low interest rates and the recent UK housing boom.

Calculating a price index

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

Category                                     Price Index            Weighting                 Price x Weight
Food                                                 106                    18                           1908
Alcohol & Tobacco                                    110                      6                           660
Clothing                                              97                    12                           1164
Transport                                            103                    15                           1545

                                                                                                        - 15 -

Housing                                              106                    22                           2332
Leisure Services                                     112                        9                        1008
Household Goods                                       95                        7                         665
Other Items                                          105                    11                           1155
                                                                           100                          10437

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

The price index for each category shows what has happened to the price level since a base year value. To
generate a weighted price index we multiply the price index for each category by its weight and then sum
these. We then divide by the sum of the weights (100) to find an overall price index (104.37) or 104.4
rounded to one decimal place.

Here is some real world data on a selected of price indices for goods and services in the UK.

       All items   Health   Transport   Communication      Tobacco   Clothing       New Cars   Second Hand Cars
1996      100.0    100.0       100.0             100.0       100.0     100.0           100.0              100.0
2000      105.6    111.6       112.7               89.3      141.2       82.2           99.8               91.2
2003      109.8    124.2       116.9               84.5      158.8       66.8           95.7               85.1

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

                                                                                                       - 16 -

    5. Aggregate Demand

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

Aggregate Demand

The identity for calculating aggregate demand (AD) is as follows:

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

        C: Consumers' expenditure on goods and services: This includes demand for consumer
        durables (e.g. washing machines, audio-visual equipment and motor vehicles & non-durable goods
        such as food and drinks which are “consumed” and must be re-purchased). Household spending
        accounts for over sixty five per cent of aggregate demand in the UK.

        I: Capital Investment – This is investment spending by companies on capital goods such as new
        plant and equipment and buildings. Investment also includes spending on working capital such as
        stocks of finished goods and work in progress.

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

        G: Government Spending – This is government spending on state-provided goods and services
        including public and merit goods. Decisions on how much the government will spend each year are
        affected by developments in the economy and also the changing political priorities of the
        government. In a normal year, government purchases of goods and services accounts for around
        twenty per cent of aggregate demand. We will return to this again when we look at how the
        government runs its fiscal policy.

        Transfer payments in the form of welfare benefits (e.g. state pensions and the job-seekers
        allowance) are not included in general government spending because they are not a payment to a
        factor of production for any output produced. They are simply a transfer from one group within the
        economy (i.e. people in work paying income taxes) to another group (i.e. pensioners drawing their
        state pension having retired from the labour force, or families on low incomes).

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

        X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection)
        into our circular flow of income and therefore add to the demand for UK produced output.

        M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the
        circular flow of income and spending. Goods and services come into the economy for us to consume
        and enjoy - but there is a flow of money out of the economy to pay for them.

        Net exports (X-M) reflect the net effect of international trade on the level of aggregate demand.
        When net exports are positive, there is a trade surplus (adding to AD); when net exports are
        negative, there is a trade deficit (reducing AD). The UK economy has been running a large trade
        deficit for several years now as has the United States.

Aggregate demand shocks

                                                                                                       - 17 -

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

Lots of unexpected events can happen which cause changes in the level of demand, output and employment
in the economy. These unplanned events are called “shocks” One of the causes of fluctuations in the level of
economic activity is the presence of demand-side shocks.

Some of the main causes of demand-side shocks are as follows:
    o   A capital investment boom e.g. a construction boom to increase the supply of new houses or to
        build new commercial and industrial buildings.
    o   A rise or fall in the exchange rate – affecting net export demand and having follow-on effects on
        output, employment, incomes and profits of businesses linked to export industries.
    o   A consumer boom abroad in the country of one of our major trading partners which affects the
        demand for our exports of goods and services.
    o   A large boom in the housing market or a slump in share prices.
    o   An unexpected cut or an unexpected rise in interest rates.

                                                                                                             - 18 -

The Aggregate Demand Curve

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

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


                                                                               A rise in the general price
                                                                               level from P1 to P2 causes
                                                                               a contraction in aggregate
                                                                               A fall in the general price
                                                                               level from P1 to P3 causes
           P1                                                                  an expansion of
                                                                               aggregate demand


                                          Y2       Y1    Y3                                Real National Income

Why does the AD curve slope downwards?

There are several explanations for an inverse relationship between aggregate demand and the price level in
an economy. These are summarised below:
   1. Falling real incomes: As the price level rises, so the real value of people’s incomes fall and
      consumers are then less able to afford UK produced goods and services.
   2. The balance of trade: As the price level rises, foreign-produced goods and services become more
      attractive (cheaper) in price terms, causing a fall in exports and a rise in imports. This will lead to a
      reduction in trade (X-M) and a contraction in aggregate demand.
   3. Interest rate effect: if in the UK the price level rises, this causes an increase in the demand for
      money and a consequential rise in interest rates with a deflationary effect on the entire economy.
      This assumes that the central bank (in our case the Bank of England) is setting interest rates in order
      to meet a specified inflation target.

Shifts in the AD curve

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

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

                                                                                                               - 19 -

                                                                              In the short run, shifts in
                                                                              aggregate demand cause
                                                                              fluctuations in the economy’s
                                                                              output of goods and services.
                                                                              In the long run, shifts in
                                                                              aggregate demand affect
                                                                              the overall price level but do
          P1                                                                  not affect output.





                                          Y3      Y1    Y2                                 Real National Income

Factors causing a shift in AD

Changes in Expectations              The expectations of consumers and businesses can have a powerful
                                     effect on planned spending in the economy E.g. expected increases in
Current spending is affected by
                                     consumer incomes, wealth or company profits encourage households
anticipated future income, profit,
                                     and firms to spend more – boosting AD. Similarly, higher expected
and inflation
                                     inflation encourages spending now before price increases come into
                                     effect - a short term boost to AD.
                                     When confidence turns lower, we expect to see an increase in saving
                                     and some companies deciding to postpone capital investment projects
                                     because of worries over a lack of demand and a fall in the expected
                                     rate of profit on investments.

Changes in Monetary Policy –         An expansionary monetary policy will cause an outward shift of the AD
i.e. a change in interest rates      curve. If interest rates fall – this lowers the cost of borrowing and the
                                     incentive to save, thereby encouraging consumption. Lower interest
(Note there is more than one
                                     rates encourage firms to borrow and invest.
interest rate in the economy,
although borrowing and savings       There are time lags between changes in interest rates and the
rates tend to move in the same       changes on the components of aggregate demand.

Changes in Fiscal Policy             For example, the Government may increase its expenditure e.g.
                                     financed by a higher budget deficit, - this directly increases AD
Fiscal Policy refers to changes in
government spending, welfare
benefits and taxation, and the       Income tax affects disposable income e.g. lower rates of income tax
amount that the government           raise disposable income and should boost consumption.
                                     An increase in transfer payments raises AD – particularly if welfare
                                     recipients spend a high % of the benefits they receive.

Economic events in the               A fall in the value of the pound (£) (a depreciation) makes imports
international economy                dearer and exports cheaper thereby discouraging imports and
                                     encouraging exports – the net result should be that UK AD rises – the
International factors such as the
                                     impact depends on the price elasticity of demand for imports and
exchange rate and foreign

                                                                                                         - 20 -

income (e.g. the economic cycle   exports and also the elasticity of supply of UK exporters in response
in other countries)               to an exchange rate depreciation.
                                  An increase in overseas incomes raises demand for exports and
                                  therefore UK AD rises. In contrast a recession in a major export
                                  market will lead to a fall in UK exports and an inward shift of
                                  aggregate demand.
                                  The UK is an open economy, meaning that a large and rising share of
                                  our national output is linked to exports of goods and services or is
                                  open to competition from imports.

Changes in household wealth       A rise in house prices or the value of shares increases consumers’
                                  wealth and allow an increase in borrowing to finance consumption
Wealth refers to the value of
                                  increasing AD. In contrast, a fall in the value of share prices will lead
assets owned by consumers e.g.
                                  to a decline in household financial wealth and a fall in consumer
houses and shares

                                                                                                                                     - 21 -

                   6. Consumer Spending and Saving

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

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

                  6                                                                         Consumer spending


Annual % change


                                                                                                    Real GDP




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

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

John Maynard Keynes developed a theory of consumption that focused primarily on
the level of people’s disposable income in determining their spending. The rate at
which consumers increase demand as income rises is called the marginal
propensity to consume. For example if someone receives an increase in income
of £2000 and they spend £1500 of this, the marginal propensity to spend is £1500 /
£2000 = 0.75. The remainder is saved – so the propensity to save would be 0.25.

The marginal propensity to spend and to save differs from person to person.
Generally, people on lower incomes tend to have a higher propensity to spend. This
has important implications when the government announces changes in direct
taxation and the level of welfare benefits.

Incomes matter in determining spending

The Bank of England has an economic model that seeks to predict what will happen to consumer spending
after various shocks. In the long term, the thing that matters most is people's real incomes. Changes in the
amount we earn are by far the most important feature determining how much we spend. Other features, such
as the value of our homes or our financial savings, matter a bit but their effect is dwarfed by changes in our
earnings. Source: Hamish McRae, the Independent, 8th August 2004

The key factors that determine consumer spending in the economy can be summarized as follows:
                  1. The level of real disposable household income
                  2. Interest rates and the availability of credit

                                                                                                                                                                   - 22 -

    3. Consumer confidence
    4. Changes in household financial wealth
    5. Changes in employment and unemployment

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

Spending on consumer durables

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

           £s at constant 2002 prices (billions)






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

                                                                                                                                          Source: Reuters EcoWin

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

Among the explanations are
    (i)                                               Falling prices for many durable products – arising from rapid advances in production
                                                      technology and the effects of globalization which means that we can now import many of
                                                      these durables more cheaply from overseas
    (ii)                                              Low interest rates which have encouraged people to spend more on “big ticket items” – there
                                                      has been a surge in demand for consumer credit
    (iii)                                             Strong consumer confidence and borrowing levels. The demand for consumer durables is
                                                      more income elastic than for non-durables which are usually staple items in people’s monthly

The Wealth Effect

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

                                                                                                                                      - 23 -

                                                        FTSE-100 Index
                                          Index of the UK's 100 leading shares - daily closing value








                         96     97        98       99        00       01         02        03          04          05       06

                                                                                                     Source: Reuters EcoWin
There is a positive wealth effect between changes in financial wealth and total consumer demand for
goods and services. For example when house prices are rising strongly, consumer confidence grows and
home-owners can also borrow some of the equity in their homes to finance major items of spending.

                                                Household Savings Ratio
                                      Percentage of disposable income that is saved, quarterly data














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

                                                                                                            Source: Reuters EcoWin
The Savings Ratio

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

                                                                                                         - 24 -

    1. Precautionary saving: People might save more because of a fear of being made unemployed. A
       nest egg of savings allows people to smooth their spending even when incomes are fluctuating.
    2. Building up potential spending power: Saving more now is a choice to defer spending today to
       finance major spending commitments in the future (e.g. saving for the deposit on a mortgage, a new
       car or a wedding). People are also becoming increasingly aware of the need to save in order to build
       up assets in occupational pension schemes because of fears that the relative value of the state
       retirement pension will fall in the years ahead.
    3. Interest rates and saving: There might be a greater willingness to save because of the incentives
       of high interest rates from banks, building societies and other financial institutions.
    4. Inheritance: Many people have a desire to pass on bequests of wealth to future generations.
    5. Saving and the life-cycle of consumers: Younger people are often net borrowers of money
       because they need to fund their degrees, purchase a property and expensive consumer durables. As
       people grow older, their incomes from work tend to rise and their spending commitments decline
       leading to an increase in net saving ahead of retirement.

The savings ratio

The household savings ratio is the level of people’s savings as a percentage of their disposable income.
The savings ratio was high during the early 1990s as a result of the high levels of unemployment and also
high interest rates. In recent years there has been a fall in the savings ratio in part because consumer
borrowing has reached record levels, fuelled in part by the rapid acceleration in house prices. At some point
the savings ratio will need to rise again as people rein back on their spending in order to repay debts on
credit cards and other forms of secured and unsecured borrowing. We have started to see a gradual rise in
the savings ratio during 2005 and the first half of 2006.

The importance of consumer confidence

The willingness of people to make major spending commitments depends on how confident they are about
both their own financial circumstances, and also the general state of the economy. Consumer confidence is
quite volatile from month to month. Some of the fluctuations are seasonal – but the underlying trend is what
really matters. One interesting aspect of recent data is that people have remained more optimistic about their
own financial situation than they have about prospects for the UK economy as a whole. This perhaps helps
to explain why people have continued to be prepared to make big-ticket purchases on new consumer
durables (many of which have been imported).

The main factors affecting consumer confidence are summarised as follows:
    o   Expectations of future income and employment
    o   The current level of interest rates and expectations of future interest rate movements
    o   Trends in unemployment and changes in perceived job security
    o   Anticipated changes in government taxation
    o   Changes in household wealth including movements in house and share prices

The consumer borrowing boom of recent years

                                                                                                                             - 25 -

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


                15    Credit card borrowing





                10   Total



                7            Borrowing secured on the value of dwellings (housing)


                 Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May
                       00          01          02          03          04          05        06
                       Total lending to individuals, 6 mth%
                       Total lending to individuals, secured on dwellings, 6 mth%
                       Total lending to individuals, consumer credit, 6 mth%
                                                                                                    Source: Reuters EcoWin

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

   1. Low unemployment – has led to rising consumer confidence.
   2. Strong growth of house prices – has encouraged mortgage equity withdrawal.
   3. Expectations of rising real incomes – people have expected their incomes to rise each year as pay
      levels have grown more quickly than inflation.
   4. Low interest rates – reducing the opportunity cost of borrowing money.
   5. Falling prices of consumer durables – many of which are bought using credit.

 The consumer credit boom has lasted nearly a decade, but there are signs that people in the UK are falling
                                    out of love with their credit card

                                                                                                           - 26 -

Strong demand for loans has boosted consumer spending and helped to keep the UK economy growing at a
time of global uncertainty. Borrowing has also contributed to the rising trade deficit in goods and services. By
the summer of 2006, the consumer borrowing boom appeared to be coming to an end. The slowdown in
credit demand has been the result of a number of factors:
    1. Rising interest rates – the Bank of England has been raising interest rates from 3.5% to 4.75% –
       this has helped to curb demand for new loans (interest rates currently at 4.5%).
    2. Weakness in the housing market and fears of a possible fall in average house prices which may
       expose homeowners to a high level of mortgage debt.
    3. Unemployment has started to edge higher and more people now expect rising unemployment,
       expectations of what might happen tomorrow affects our behaviour today!
    4. The consumer debt mountain has reached high levels – well over £1 trillion – and many people
       are now scaling back their borrowing and saving more as a precaution against a future downturn.
    5. Possible consumer satiation – how many plasma TV screens or digital cameras do you need?
       There are limits to how many consumer durables people need to buy!

Consumer spending and the UK balance of payments

Consumers in Britain have a high marginal propensity to import goods and services so that, when their
real incomes are rising and their spending increases, so too does the demand for imports. Unless there is a
corresponding increase in UK exports overseas, then the balance of trade in goods and services will move
towards heavier deficit. This has been the case in the UK over the last five or six years. In the medium term if
demand for imports rises and the level of import penetration into the domestic economy continues to rise,
then national output and employment will weaken and this will work its way through the circular flow to
reduce real incomes. Living standards are reduced in the long run if our export industries are unable to
compete with output produced in other countries.

                                                                                                        - 27 -

    7. Capital Investment

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

Definition of Capital Investment
    1. Capital investment is defined as spending on capital goods such as new machinery, buildings
       and technology so that the economy can produce more consumer goods in the future.
    2. A broader definition of investment would encompass spending on improving the human capital of
       the workforce - for example extra investment in training and education to improve the skills and
       competences of workers.
    3. Most economists agree that investment is vital to promoting long-run economic growth through
       improvements in productivity and a country’s productive capacity.

Gross and Net Investment

Gross investment spending includes an estimate for capital depreciation since some investment is
needed to replace technologically obsolete plant and machinery. Providing that net investment is positive,
businesses are expanding their capital stock giving them a higher productive capacity and therefore meet a
higher level of demand in the future.

The Economic Importance of Capital Investment

Firms often invest in new capital goods to exploit internal economies of scale. This, together with
technological advances that are often built into new machinery, is vital to improving the UK's
competitiveness and to causing an outward shift in the country’s production possibility frontier.

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

                                                                                                                      - 28 -

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

   Output of Capital



                  C3                                                                C

                  C1                                                     A


                                                    X2              X1         X3                                 Output of
                                                                                                            Consumer Goods

In the short run, devoting more a country’s scarce resources to the production of investment goods (a
process known as capital accumulation) might require a reduction in today’s output of consumer goods and
services (lower consumption would be accompanied by a rise in saving). The re-allocation of resources
towards capital goods would be shown by a movement from point A to B on the production possibility

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

Investment affects AD as well as Aggregate Supply (AS)

It should be remembered that investment is also a component of AD. Businesses involved in developing,
manufacturing, testing, distributing and marketing the capital goods themselves stand to benefit from
increased orders for new plant and machinery.

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

    o    Demand side effects: Increase spending on capital goods – affects industries that manufacture the
         technology / hardware / construction sector
    o    Supply side effects: Investment is linked to higher productivity, an expansion of a country’s
         productive capacity, a reduction in unit costs (e.g. through the exploitation of economies of scale) –
         and therefore a source of an increase in LRAS (trend growth)

                                                                                                                                             - 29 -

                                                                       LRAS1             LRAS2


                                                                                        AD1              AD2

                                                                  Y1           Y2                YFC2

                                                                                                    Real National Income
It is not just the level of capital investment which is important but also the quality of the increase in the capital
stock. A high level of investment on its own may not be sufficient to create an increase in LRAS – workers
need to be trained to work the new machinery and there may be time lags between new capital spending
and the knock-on effects on output and productivity in particular. Also, if there is insufficient demand in a
market, a high level of capital investment may lead to excess capacity emerging in industries – putting
downward pressure on prices and profits

                                              Gross Fixed Capital Investment by Businesses
                                                         Investment at constant 2001 prices, £ billion




       2001 GBP (billions)








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

                                                                                                                    Source: Reuters EcoWin

                                                                                                          - 30 -

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

Key Factors Determining Capital Investment Spending

Several factors influence how much businesses are prepared to commit to investment projects:
    1. Real interest rates: Interest rates affect the cost of borrowing money to finance investment. If the
       rate of interest increases, the cost of funding investment increases, reducing the expected rate of
       return on capital projects. A second factor is that higher interest rates raise the opportunity cost of
       using profits to finance investment – i.e. a business might decide that the cost of financing new
       capital is too high and that it could earn a higher rate of return by simply investing the cash. Low
       interest rates are not always good news for business investment. Recently economists have become
       concerned that low interest rates has reduced the cost of capital for businesses to such an extent
       that some low quality capital investment projects have been given the go ahead and much of this
       investment has proved to be disappointing.
    2. The rate of growth of demand: Investment tends to be stronger when consumer demand is rising,
       giving businesses an extra incentive to invest to expand their capacity to meet this demand. Higher
       expected sales also increase potential profits – in other words, the price mechanism should allocate
       extra funds and factor inputs towards investment goods into those markets where consumer demand
       is rising.
    3. Corporate taxes: Corporation tax is paid on profits. If the government reduces the rate of
       corporation tax (or increases investment tax-allowances) there is a greater incentive to invest. Britain
       has relatively low rates of company taxation compared to other countries inside the EU. This is a
       factor that helps to explain why Britain has been a favoured venue for inward investment from
       overseas during the last decade.
    4. Technological change and degree of market competition: In markets where technological
       change is rapid, companies may have to commit themselves to higher levels of investment to keep
       pace with the shifting frontier of technology and remain competitive. In markets where there is a
       premium on a business keeping costs down but at the same time, achieving year on year gains in
       efficiency and quality of service, there is also an incentive to keep capital investment spending high.
    5. Business confidence: Business confidence can be vital in determining whether to go ahead with an
       investment project. When confidence is strong then planned investment will rise. The Confederation
       of British Industry ( publishes a quarterly survey of confidence that gives economists
       an insight into likely trends in investment from manufacturing industry – although it must be
       remembered that over 70% of total GDP now comes from the service sector. In recent years, capital
       spending by service businesses has grown strongly – but manufacturing investment has weakened.

Business investment and the economic cycle

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

                                                                                                            - 31 -

    8. Aggregate Supply

Having looked at the components of aggregate demand, we now turn to the supply-side of the economy.
Aggregate supply tells us something about whether producers across the economy can supply us with the
goods and services that we need.

A definition of aggregate supply

Aggregate supply (AS) measures the volume of goods and services produced within the economy at a
given price level. In simple terms, aggregate supply represents the ability of an economy to produce goods
and services either in the short-term or in the long-term. It tells us the quantity of real GDP that will be
supplied at various price levels. The nature of this relationship will differ between the long run and the short
    o   In the long run, the aggregate-supply curve is assumed to be vertical
    o   In the short run, the aggregate-supply curve is assumed to be upward sloping

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

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

The short run aggregate supply curve



                                                                      An expansion of
                                                                      national output


                                                                      A contraction of
           P1                                                         national output


                                                    Y1     Y2   Yfc                         Real National Income

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

                                                                                                                   - 32 -

   1. Negative output gap: At low levels of real national income where actual GDP < potential GDP,
      firms have a large amount of spare capacity and can expand their output without paying their
      workers overtime. The SRAS curve is therefore drawn as elastic
   2. Positive output gap: As national output expands and the economy heads towards full capacity, so
      “supply bottlenecks and shortages” may start to appear in some sectors and industries. Workers
      receive the same wage rate but require payment of overtime and bonuses to work longer hours and
      increase GDP – SRAS is becoming more inelastic
   3. Diminishing returns? As national output expands, older less productive machinery may be used
      and less efficient workers hired. This means that while wage rates remain constant, unit costs of
      production may rise and thus the SRAS slopes upwards
   4. Full-capacity output at LRAS. Eventually the economy cannot increase the volume of output
      further in the short-term no matter what bonus or overtime payments on offer, at this point SRAS is
      perfectly inelastic – the economy has reached full-capacity (the LRAS curve)



                                                                       Short run aggregate supply is inelastic
                                                                       here – a rise in AD will have more of an
                                                                       effect on the general price level than it
           P2                                                          will on the volume of real national


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

                                                     Y1    Y2    Yfc                             Real National Income

Shifts in short run aggregate supply (SRAS)

Shifts in the SRAS curve can be caused by the following factors
   1. Changes in unit labour costs: Unit labour costs are defined as wage costs adjusted for the level of
      productivity. For example a rise in unit labour costs might be brought about by firms agreeing to pay
      higher wages or a fall in the level of worker productivity. If unit wage costs rise, this will eventually
      feed through into higher prices (this is known as an example of “cost-push inflation”)
   2. Commodity prices: Changes to raw material costs and other components e.g. the world price of oil,
      copper, aluminium and other inputs in many production processes will affect a firm’s costs. These
      costs might be affected by a change in the exchange rate which causes fluctuations in the prices of
      imported products. A fall (depreciation) in the exchange rate increases the costs of importing raw
      materials and component supplies from overseas
   3. Government taxation and subsidy: Changes to producer taxes and subsidies levied by the
      government as part of their fiscal policy have effects on the costs of nearly every producer – for
      example an increase in taxes designed to meet the government’s environmental objectives will
      cause higher costs and an inward shift in the short run aggregate supply curve. A rise in VAT on raw
      materials will have the same effect.

                                                                                                         - 33 -

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

Shifts in aggregate supply in the short run

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

                        SRAS1 – SRAS2: A fall in aggregate supply caused by an increase in costs –
                        less output can be supplied at each and every price level
                        SRAS1 – SRAS3: A rise in aggregate supply caused by a fall in production
                        costs – more output can be supplied at each and every price level

      Inflation                                                         LRAS




                                                                  Yfc           Real National Income

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

                                                                                                           - 34 -

Long run aggregate supply (LRAS)

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

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

                                               Y*t = f (Lt, Kt, Mt)
    o   Y* is an aggregate measure of potential output in an economy
    o   T is the time period under consideration
    o   L represents the quantity and ability of labour input available to the production process
    o   K represents the available capital stock, i.e. machinery, buildings and infrastructure
    o   M represents the availability of natural resources and materials for production i.e. land

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

The vertical long run aggregate supply curve

In the long run we assume that aggregate supply is independent of the price level. As a result we draw the
long run aggregate supply curve as vertical. In drawing the LRAS as vertical, we are saying that there is a
maximum level of physical output that the economy can produce. Neo-classical economists view the LRAS
curve as being perfectly inelastic at a level of output where actual GDP has achieved its potential. There will
be no unused labour in that all those who are available for employment at the prevailing wage rate will be in
employment – in other words, a full-employment level of national income has been reached. There will
remain the problem of voluntary unemployment.

According to the neo-classical school of economics, real GDP will in the long run always return to the
level at which all available labour resources have found employment.

Causes of shifts in the long run aggregate supply curve

Any change in the economy that alters the natural rate of growth of output (i.e. trend growth) shifts the
long-run aggregate-supply curve.

Improvements in productivity and efficiency or an increase in the stock of capital and labour resources cause
the LRAS curve to shift out. This is shown in the diagram below. The result is that a great volume of national
output can be produced at any given price level.

                                                                                                       - 35 -

                                                                   LRAS1      LRAS2        LRAS3


                                              SRAS2              SRAS3

                                                                    YFC1        YFC2       YFC3
                                                                                     Real National Income

The fundamentals of increasing long run aggregate supply

These all relate to the supply-side of the economy
    1. Expanding the labour supply - e.g. by improving incentives for people to search for and then
       accept new jobs as they become available. Government policies seek to expand the available
       labour supply by encouraging more people to join the labour force and become economically
       active. The UK government has also been encouraging an influx of migrant labour which has added
       to the supply of labour although it is also causing concern about some of the social and political
    2. Increase the productivity of labour and capital – e.g. by investment in training of the labour force
       and improvements in the quality of management and human resource management
    3. Increase the occupational and geographical mobility of labour to reduce certain types of
       unemployment for example the level of structural unemployment which is caused by occupational
       immobility of labour. A reduction in structural unemployment will reduce the scale of unemployment
       and provide the economy with a great supply of available labour.
    4. Expand the capital stock – i.e. increase the level of capital investment and research and
       development spending by firms
    5. Increase business efficiency by promoting greater competition within and between markets
    6. Stimulate a faster pace of invention and innovation – this will hopefully in the long term promote
       lower production costs and also improvements in the dynamic efficiency of markets

Aggregate supply shocks

Aggregate supply shocks might occur when there is
    o    A sudden rise in oil prices or other essential inputs
    o    The invention and diffusion of a new production technology

                                                                                                                      - 36 -

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







                         01        02                  03                   04              05            06
                                                                                             Source: Reuters EcoWin

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

In the long-run

In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous
seasons they can only tell us that when the storm is long past the ocean is flat again.”
                                                                                  John Maynard Keynes, 1936

                                                                                                              - 37 -

    9. Macroeconomic Equilibrium

We now put aggregate demand and supply to together to consider the idea of equilibrium for the economy.

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

Macro-economic equilibrium is established when AD intersects with SRAS. This is shown in the diagram
below. At price level P1, AD is equal to SRAS – i.e. at this price level, the value of output produced within the
economy equates with the level of demand for goods and services. The output and the general price level in
the economy will tend to adjust towards this equilibrium position. If the general price level is too high for
example, there will be an excess supply of output and producers will experience an increase in unsold
stocks. This is a signal to cut back on production to avoid an excessive level of inventories. If the price level
is below equilibrium, there will be excess demand in the short run leading to a run down of stocks – a signal
for producers to expand output.

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

      Inflation                                                    LRAS

                                                  Equilibrium Point

                  At price level P2 – there
                  would be excess supply

                                                                            At the equilibrium output
                                                                              in this example, the
           Pe                                                               economy is still operating
                  At price level P1 – there                                    below full capacity
                  would be excess demand



                                                        Ye            Yfc              Real National Income

                                                                                                        - 38 -

                  AD1 – AD2 is an outward shift of AD causing an expansion of short run aggregate
                  supply, a rise in real national output and an increase in the general price level
                  AD1 – AD3 is an inward shift of AD causing a contraction of short run aggregate
                  supply, a fall in real national output and a decrease in the general price level
      Inflation                                                       LRAS






                                            Y3           Y1 Y2      Yfc               Real National Income

Changes in short-run aggregate supply (SRAS)

Suppose that higher productivity of labour and capital inputs together with lower raw material costs such as
cheaper oil and steel causes the short run aggregate supply curve to shift outwards. (Assume that there is
no shift in AD). The next diagram shows what is likely to happen. SRAS1 shifts outwards to SRAS3 and a
new macroeconomic equilibrium will be established at Y3.

                                                                                                           - 39 -

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

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






                                                     Y2   Y1 Y3     Yfc                 Real National Income

Equilibrium using a linear aggregate supply curve

In the next diagram we see the effects of two inward shifts in AD. This might be caused for example by a
decline in business confidence (reducing planned investment demand) and a fall in exports following a global
downturn. It might also be caused by a cut in government spending or a rise in interest rates (announced by
the Bank of England).

The result of the inward shift of AD is a contraction along the short run aggregate supply curve and a fall in
national output (i.e. a recession). This causes downward pressure on the general price level and takes the
equilibrium level of national output further away from the full capacity level of national income as indicated by
the LRAS curve. We would expect to see a rise in unemployment.

                                                                                                                 - 40 -





                                                                    AD3        AD2   AD1

                                        Y3   Y2 Y1      Yfc                                    Real National Income
The Output Gap

The output gap (or GDP gap) is an important concept in macroeconomics. It is defined as the difference
between the actual level of national output and its potential level and is usually expressed as a percentage of
the level of potential output.
                  Showing a negative and a positive output gap using an AS – AD diagram



          P2                                                                               Positive Output Gap
                                                                                           Y2 > Yfc

                            Negative Output Gap
                            Y1 < Yfc


                                                          Y1    Yfc       Y2                  National Income

Negative output gap – downward pressure on inflation

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

                                                                                                                               - 41 -

means there is downward pressure on real wage rates. In the next time period, a fall in wage rates shifts
SRAS downwards until actual and potential GDP are identical – assuming labour markets are flexible.

Positive output gap – upward pressure on inflation

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

                                United Kingdom, Output gap of the total economy
                                      Actual GDP - Potential GDP, measured as a percenage of potential GDP







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

                                                                                                      Source: Reuters EcoWin

The last boom in the late 1980s left the UK with a large positive output gap, one of the reasons why we say a
sharp acceleration in inflation before the recession of the early 1990s (high inflation required very high
interest rates to control it and this squeezed business and consumer confidence and spending). At the end of
the recession in 1992 the output gap was negative – allowing the economy to grow for several years without
the fear of demand-pull inflationary pressure.

Over the last six or seven years, the output gap has remained close to zero. The Bank of England has
managed quite successfully through its interest rate strategy to keep aggregate demand growing more or
less in line with the economy’s productive potential. The recent global economic slowdown has hit GDP
growth in the UK (leading to weak exports and falling investment) – but the economy continues to operate
fairly close to its potential.

                                                                                                                                                      - 42 -

    10. The Macroeconomic Cycle

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

                                                                      United Kingdom, Gross Domestic Product

        GDP at constant 2001 prices (billions)






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

                                                                                                                             Source: Reuters EcoWin

National output rarely rises or falls at a constant rate. All countries experience a business cycle or
economic cycle where the rate of growth of national production, incomes and spending fluctuates. The
length and volatility of each cycle changes over time as the structure of an economy evolves and previously
observed economic relationships appear to change.

There are different stages of an economic cycle, each of which has observed characteristics – but no
economic cycle is ever the same!


A boom occurs when real national output is rising at a rate faster than the trend rate of growth. In boom
conditions, national output and employment are expanding and aggregate demand is high.

Some of the main characteristics of an economic boom include:
    o        A fast growth of consumption of durable and non-durable goods helped by rising real incomes,
             strong consumer confidence and perhaps a surge in house prices and other forms of personal
    o        A pick up in the demand for capital investment goods as businesses look to expand their capacity in
             order to meet rising demand and to achieve higher profits
    o        Rising employment (falling unemployment) and higher real wages for people in jobs
    o        A high and rising demand for imported products which may cause the economy to run a larger trade
             deficit and cannot supply all of the goods and services that consumers are demanding
    o        Government tax revenues will be rising quickly as people are earning and spending more and
             companies are making larger profits – this gives the government the option of raising its own
             spending in priority areas such as education, health and transport

                                                                                                          - 43 -

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

            All countries experience regular business cycles – some are more volatile than others!


A slowdown occurs when the rate of growth decelerates – but national output is still rising. If the economy
continues to grow without falling into outright recession, this is known as a soft-landing.


A recession means a fall in the level of real national output (i.e. a period when the rate of growth is
negative) leading to a contraction in employment, incomes and profits. The last recession in Britain lasted
from the summer of 1990 through to the autumn of 1992. When real GDP reaches a low point, the economy
has reached the trough – and with hope (and perhaps some luck!) a recovery is imminent.

An economic slump or a depression is a prolonged and deep recession leading to a significant fall in output
and average living standards. The main characteristics of an economic recession are:
    o   Declining aggregate demand for goods and services
    o   Contracting employment and rising unemployment due to plant closures and an increased level of
        worker redundancies
    o   A fall in business confidence & profits leading to a decrease in capital investment spending
    o   De-stocking and heavy price discounting from businesses left with excess capacity and who decide
        to cut their prices to generate much needed cash flow and maintain output
    o   Reduced inflation and falling demand for imports
    o   Increased government borrowing (i.e. a rising budget deficit) because spending rises on welfare
        payments and tax revenues from individuals and companies fall
    o   Lower interest rates from central bank – who might decide to relax monetary policy but cutting
        interest rates in a bid to stimulate confidence and spending


A recovery occurs when real national output picks up from the trough reached at the low point of the
recession. The pace of recovery depends in part on how quickly AD starts to rise after the economic
downturn. And, the extent to which producers raise output and rebuild their stock levels in anticipation of a

                                                                                                      - 44 -

rise in demand. The state of business confidence plays a key role here. Any recovery in production might be
subdued if businesses anticipate that a recovery will be only temporary or weak in scale.

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

                                                                                                             - 45 -

    11. Multiplier and Accelerator Effects

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

The multiplier process

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

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

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

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

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

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

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

The Multiplier and Keynesian Economics

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

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

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

                                                                                                        - 46 -

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

 The new Terminal 5 building at Heathrow airport

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

                                                                                                                 - 47 -

                   Differences in the size of the multiplier effect

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

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

       Inflation                                                         LRAS








                                         Y1                 Y2 Y3 Y4 Yfc                   Real National Income

The construction boom and multiplier effects

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

The study provides compelling evidence on the multiplier effects of major capital investment projects. 'One
characteristic of construction activity is that it feeds through to many other related businesses. It has
"backward linkages" into the likes of building materials; steel, architectural services, legal services and
insurance, and most of these linkages tend to result in jobs close to home. This makes a boom in
construction peculiarly powerful in fuelling expansion in the economy - for a given lift in building orders, the
multiplier effect may be well over two. This means that every building job created will generate at least two
others in related areas and in downstream activities such as retailing, which benefits when building workers
spend their wages. Other industries, particularly those where much of the output value comes in the form of
imported components, might have a multiplier of less than 1.5 for new projects'.

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

                                                                                                           - 48 -

The accelerator effect

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

A good example of this in recent years is the telecommunications industry. Capital investment in this sector
surged to record highs in the second half of the 1990s, driven by a fast pace of technological advance and
huge increases in the ICT budgets of corporations, small-to-medium sized businesses, and extra capital
investment by the public sector (including education and health).

The telecommunications industry invested giant sums in building bigger and faster networks, but demand
has slowed in the first three of the decade, leaving the industry with a vast amount of spare capacity (an
under-utilisation of resources). Capital investment spending in the telecommunications industry has fallen
sharply in the last three years – the accelerator mechanism working in reverse.

     Inflation                                          Rate of
                                                     Interest (%)




                                                      AD1                                        demand (2)

                                   Y1   Y2   Y3                         I1         I2
                                        Real National Income                              Demand for capital
                                                                                          investment (I)

                 Aggregate demand and the accelerator effect

                 The strength of demand for goods and services and in particular the level of consumer
                 spending has an impact on the planned level of capital investment spending by private
                 sector businesses.
                 When consumption grows strongly, this increases short run output and it can lead to
                 higher prices and profits for producers who will be operating with less spare capacity.
                 If business confidence and profits are high, we can see an accelerator effect at work
                 with a rise in planned capital investment at each prevailing rate of interest. This is
                 shown in the right hand diagram above.

                                                                                                            - 49 -

    12. Economic Growth

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

Defining economic growth

Economic growth is best defined as a long-term expansion of the productive potential of the economy.
Sustained economic growth should lead higher real living standards and rising employment. Short term
growth is measured by the annual % change in real GDP.

Growth and the Production Possibility Frontier

An increase in long run aggregate supply is illustrated by an outward shift in the PPF.

   Output of Capital

                  C2                                              C


                                               X2             X1                                Output of
                                                                                          Consumer Goods

Advantages of Economic Growth

Sustained economic growth is a major objective of government policy – not least because of the benefits that
flow from a growing economy.
    (1) Higher Living Standards – for example measured by an increase in real national income per head
        of population – see the evidence shown in the chart below
    (2) Employment effects: Growth stimulates higher employment. The British economy has been
        growing since autumn 1992 and we have seen a large fall in unemployment and a rise in the number
        of people employed.
    (3) Fiscal Dividend: Growth has a positive effect on government finances - boosting tax revenues and
        providing the government with extra money to finance spending projects
    (4) The Investment Accelerator Effect: Rising demand and output encourages investment in new
        capital machinery – this helps to sustain the growth in the economy by increasing long run aggregate

                                                                                                                                      - 50 -

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

Rising national income boosts living standards

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

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









                                         Real GDP growth


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

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

Disadvantages of economic growth

There are some economic costs of a fast-growing economy. The two main concerns are firstly that growth
can lead to a pick up in inflation and secondly, that growth can have damaging effects on our environment,
with potentially long-lasting consequences for future generations.
    (1) Inflation risk: If the economy grows too quickly there is the danger of inflation as demand races
        ahead of aggregate supply. Producer then take advantage of this by raising prices for consumers
    (2) Environmental concerns: Growth cannot be separated from its environmental impact. Fast growth
        of production and consumption can create negative externalities (for example, increased noise and
        lower air quality arising from air pollution and road congestion, increased consumption of de-merit
        goods, the rapid growth of household and industrial waste and the pollution that comes from
        increased output in the energy sector) These externalities reduce social welfare and can lead to
        market failure. Growth that leads to environmental damage can have a negative effect on people’s
        quality of life and may also impede a country’s sustainable rate of growth. Examples include the
        destruction of rain forests, the over-exploitation of fish stocks and loss of natural habitat created
        through the construction of new roads, hotels, retail malls and industrial estates.

                                                                                                            - 51 -

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

The trend rate of economic growth

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

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

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

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

Demand and supply factors influence growth of GDP

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

                                                      Adapted from a Treasury paper

The importance of the supply-side of the economy

The trend rate of growth is determined mainly by the supply-side capacity of a country – i.e. the extent to
which LRAS increases year-on-year to meet a higher level of demand for goods and services. Potential
output in the long run depends on the following factors
    o   The trend growth of the working population i.e. the size of the active labour supply (e.g. those
        people able available and willing to find paid employment)

                                                                                                                      - 52 -

    o    The growth of the nation’s stock of capital – driven by the level of capital investment in new
         buildings, machinery, plant and technology
    o    The trend rate of growth of factor productivity (including labour productivity) – a measure of gains
         in factor efficiency
    o    Technological improvements driven by innovation and invention which reduce the costs of
         supplying goods and services and which lead to an outward shift in a country’s production possibility

Long Run Aggregate Supply and the Trend Rate of Growth

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

                                                         LRAS1               LRAS2
    Inflation                                                                          An outward shift in LRAS helps to
                                                                                      increase the economy’s underlying
                                                                                      trend rate of growth – it represents
                                                                                         an increase in potential GDP



                                                  Y1              Y1          YFC2                      National Income
Potential output in the long run depends on the following factors

(1) The growth of the labour force e.g. those people able available and willing to find employment

If the government can increase the number of people willing and able to actively seek paid employment, then
the employment rate increases leading to a higher output of goods and services. The Government has
invested heavily in a number of employment schemes designed to raise employment including New Deal
and reforms to the tax and benefit system. Changes in the age structure of the population also affect the
total number of people seeking work. And we might also consider the effects that migration of workers into
the UK from overseas, including the newly enlarged European Union, can have on our total labour supply

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

A rise in capital investment adds directly to GDP in the sense that capital goods have to be designed,
produced, marketed and delivered. Higher investment also provides workers with more capital to work with.
New capital also tends to embody technological improvements which providing workers have sufficient skills
and training to make full and efficient use of their new capital inputs, should lead to a higher level of
productivity after a time lag.

(3) The trend rate of growth of productivity of labour and capital. For most countries it is the growth of
productivity that drives the long-term growth. The root causes of improved efficiency come from making
markets more competitive and achieving better productivity within individual plants and factories.
Increased investment in the human capital of the workforce is widely seen as essential if the UK is to

                                                                                                       - 53 -

improve its long run productivity performance – for example – increased spending on work-related training
and improvement in the UK education system at all levels.

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

The current growth phase for the UK is the longest period of continuous growth for over forty years.

                                                                                                                             - 54 -

    13. Inflation

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

What is inflation?

Inflation is best defined as a sustained increase in the general price level leading to a fall in the
purchasing power or value of money. The greatest falls in the value of money came during the mid-late
1970s and again in the late 1980s when there was acceleration in the rate of inflation in the UK. In contrast,
the last fifteen years have seen much lower rates of inflation – and as a result, money has held value better.
The next chart shows the UK consumer price index since 1970.

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








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

                                                                                                    Source: Reuters EcoWin
The value of money refers to the amount of goods and services £1 can buy and is inversely proportionate to
  the rate of inflation. Inflation reduces the value of money. When prices are increasing, then the value of
                                                   money falls.

The rate of inflation is measured by the annual percentage change in the level of consumer prices. The
British Government has set an inflation target of 2% using the consumer price index (CPI). It is the job of
the Bank of England to set interest rates so that AD is controlled and the inflation target is reached. Since the
Bank of England was made independent, inflation has stayed comfortably within target range. Indeed Britain
has one of the lowest rates of inflation inside the EU.

                                                                                                                              - 55 -

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



                                                                   CPI Inflation target = 2%






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

                          ar 12 months
                                                                                                     Source: Reuters EcoWin

There has been a fall in average inflation rates in most of the world’s developed countries including the UK
over the last fifteen years. Indeed lower inflation seems to have become a global phenomenon. Japan has
experienced negative inflation (i.e. price deflation) over recent years (although in 2006, this period of price
deflation came to an end) and the German economy has also come close to experiencing deflation with
inflation of less than one per cent.


Price deflation is when the rate of inflation becomes negative. I.e. the general price level is falling and the
value of money is increasing. Some countries have experienced deflation in recent years – good examples
include Japan and China. In Japan, the root cause of deflation was slow economic growth and a high level
of spare capacity in many industries that was driving prices lower. In China, economic growth has been
rapid – but the huge amount of capital investment and rising productivity has led to economies of scale
being exploited and a fall in production costs.

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

                                                                                                                               - 56 -

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

                                                                               Clothing and Footwear




                                                      Audio-visual and photo equipment


                          Oct Jan Apr Jul   Oct Jan Apr       Jul   Oct Jan Apr      Jul   Oct Jan Apr          Jul   Oct
                            01        02                     03                     04                         05
                                                                                                      Source: Reuters EcoWin


 A 500 billions bill with most zeros in the economy history. The product of hyperinflation in Yugoslavia 1993

Hyperinflation is extremely rare. Recent examples include Yugoslavia Argentina, Brazil, Georgia and Turkey
(where inflation reached 70% in 1999). The classic example of hyperinflation was of course the rampant
inflation in Weimar Germany between 1921 and 1923. When hyperinflation occurs, the value of money
becomes worthless and people lose all confidence in money both as a store of value and also as a medium
of exchange. The current hyperinflation in Zimbabwe is a good example of the havoc that can be caused
when price inflation spirals out of control.

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

The main causes of inflation

                                                                                                           - 57 -

Inflation can come from several sources: Some come direct from the domestic economy, for example the
decisions of the major utility companies providing electricity or gas or water on their prices for the year
ahead, or the pricing strategies of the leading food retailers based on the strength of demand and
competitive pressure in their markets. A rise in government VAT would also be a cause of increased
domestic inflation because it increases a firm’s production costs.

Inflation can also come from external sources, for example an unexpected rise in the price of crude oil or
other imported commodities, foodstuffs and beverages. Fluctuations in the exchange rate can also affect
inflation – for example a fall in the value of sterling might cause higher import prices – which feeds through
directly into the consumer price index.

We make a simple distinction between demand pull and cost push inflation.

Demand-pull inflation

Demand-pull inflation is likely when there is full employment of resources and aggregate demand is
increasing at a time when SRAS is inelastic. This is shown in the next diagram:

                                                                  LRAS               SRAS2





                                                           Y1      Yfc   Y2    National Income

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

The main causes of demand-pull inflation

Demand pull inflation is largely the result of the level of AD being allowed to grow too fast compared to what
the supply-side capacity can meet. The result is excess demand for goods and services and pressure on
businesses to raise prices in order to increase their profit margins.

Possible causes of demand-pull inflation include:

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

                                                                                                          - 58 -

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

    3. Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand – for
       example in raising demand for loans or in causing a sharp rise in house price inflation

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

Cost-push inflation

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

    1. Component costs: e.g. an increase in the prices of raw materials and other components used in the
       production processes of different industries. This might be because of a rise in world commodity
       prices such as oil, copper and agricultural products used in food processing

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

    3. Higher indirect taxes imposed by the government – for example a rise in the specific duty on
       alcohol and cigarettes, an increase in fuel duties or a rise in the standard rate of Value Added Tax.
       Depending on the price elasticity of demand and supply for their products, suppliers may choose to
       pass on the burden of the tax onto consumers

Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. The fall
in SRAS causes a contraction of national output together with a rise in the level of prices.

     Inflation                                                       LRAS






                                                    Y2   Y1        Yfc                  Real National Income
Which government policies are most effective in reducing inflation?

                                                                                                               - 59 -

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

Inflation can be reduced by policies that (i) slow down the growth of AD or (ii) boost the rate of growth of
aggregate supply (AS). The main anti-inflation controls available to a government are:

    1. Fiscal Policy: If the government believes that AD is too high, it may reduce its own spending on
       public and merit goods or welfare payments. Or it can choose to raise direct taxes, leading to a
       reduction in disposable income. Normally when the government wants to “tighten fiscal policy” to
       control inflation, it will seek to cut spending or raise tax revenues so that government borrowing (the
       budget deficit) is reduced. This helps to take money out of the circular flow of income and spending

    2. Monetary Policy: A tightening of monetary policy involves higher interest rates to reduce
       consumer and investment spending. Monetary policy is now in the hand of the Bank of England –it
       decides on interest rates each month.

    3. Supply side economic policies: Supply side policies include those that seek to increase
       productivity, competition and innovation – all of which can maintain lower prices.

The most appropriate way to control inflation in the short term is for the British government and the Bank of
England to keep control of aggregate demand to a level consistent with our productive capacity. The
consensus among economists is that AD is probably better controlled through the use of monetary policy
rather than an over-reliance on using fiscal policy as an instrument of demand-management. But in the long
run, it is the growth of a country’s supply-side productive potential that gives an economy the flexibility to
grow without suffering from acceleration in cost and price inflation.

Why has inflation remained low in the UK over recent years?

The last twelve years has been a period of very low and stable inflation. No one factor explains this – but
among them we can highlight the following:
    1. Low wage inflation from the labour market: Wages have been growing at a fairly modest rate in
       recent years despite a large fall in unemployment. This has been helped by a fall in expectations of
    2. Low global inflation and deflation in some countries: There has been a clear fall in the average
       rate of consumer prices inflation among leading economies, and this decline in global inflation has
       filtered through to the UK. World inflation has stayed low despite the recent increases in the prices of
       many of the world’s globally traded commodities.
    3. The effectiveness of monetary policy in the UK: The success of the Bank of England through
       monetary policy in keeping aggregate demand under control through interest rate changes
    4. Increased competition: Many markets have become more contestable in the last decade and this
       extra competition has placed a discipline on businesses to control their costs, reduce profit margins
       and seek improvements in efficiency. Many UK businesses face severe pressure from foreign
       competition as the process of globalisation continues
    5. The strength of the exchange rate: The recent strength of the pound has lowered the cost of
       imported products and also squeezes demand for UK exporters
    6. Information technology effects: The rapid expansion of information and communication
       technology has helped to reduce costs and has made prices more transparent for consumers – e-
       commerce has contributed to falling prices in many markets

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

                                                                                                                            - 60 -

                           Consumer Price Inflation for Goods and Services
                                                       Annual Percentage Change


          4 Inflation in Services


          2 Goods and Services Together



               Inflation in Goods

                     00                 01             02               03                  04        05           06

                     All items (CPI), Chg Y/Y                 All services, Index [ar 12 months]
                     All goods, Index [ar 12 months]
                                                                                                   Source: Reuters EcoWin

                                                                                                        - 61 -

    14. Employment and Unemployment

We now turn our attention to the labour market and consider why people find themselves out of work and
cannot find a paid job. Unemployment imposes heavy economic and social costs; we look at which policies
are likely to be most effective in keeping unemployment as low as possible.

Defining and measuring unemployment

Officially, the unemployed are people who are registered as able, available and willing to work at the going
wage rate but who cannot find work despite an active search for work. This last point is important for to be
classified as unemployed, one must show evidence of being active in the labour market.

There are two main measures of unemployment in the UK:

        o   The Claimant Count measure of unemployment includes those unemployed people who are
            eligible to claim the Job Seeker's Allowance (JSA) or who have enough National Insurance
            Credits. People who satisfy the criteria receive the JSA for six months before moving onto
            special employment measures including the New Deal Programme. The Claimant Count is a
            “head-count” of people claiming unemployment benefit.

        o   The Labour Force Survey covers those who are without any kind of job including part time work
            but who have looked for work in the past month and are able to start work in the next two weeks.
            The figure also includes those people who have found a job and are waiting to start in the next
            two weeks.

On average, the labour force survey measure has exceeded the claimant count by about 400,000 in recent
years. Because it is a survey (albeit a large one and one that provides a rich source of data on the
employment status of thousands of households across the UK), we must remember that there will always be
a sampling error in the data. The Labour Force Survey measure is the internationally agreed definition of
unemployment and therefore the measure that best allows cross-country comparisons of unemployment

Under-counting the true level of unemployment

Unemployment in Britain may be twice as high as official statistics show. Research on the UK labour market
by economists at HSBC bank takes into account anybody who is 'economically inactive', but looking for a job,
not just those who are eligible for unemployment benefits. The report estimates that there are 3.4m Britons
who are unemployed, as opposed to the International Labour Organisation's estimate of 1.4m people.
Britain's official unemployment rate is 4.8% - one of the lowest rates of unemployment in the European Union

                                                                 Adapted from newspaper reports, July 2004

                                                                                                                                                            - 62 -

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


       per cent of the labour force



                                      6                                                                                             Labour Force Survey




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

                                                Labour Force Survey measure          Claimant Count measure
                                                                                                                                   Source: Reuters EcoWin

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

                                            Labour Force Survey Unemployment                                  Claimant Count
                                                                                                              (seasonally adjusted)
                                            Level                  Annual change           Rate               Level           Annual change            Rate
                                            000s                   000s                    %                  000s            000s                     %
1990                                                    2,004                 -102                 6.9               1,648               -120                 5.5
1993                                                    2,953                  157                10.5               2,877                135                 9.7
1997                                                    2,045                 -299                 7.2               1,585               -503                 5.3
1998                                                    1,783                 -262                 6.3               1,348               -237                 4.5
1999                                                    1,759                  -24                 6.1               1,248               -100                 4.1
2000                                                    1,638                 -121                 5.6               1,088               -160                 3.6
2001                                                    1,431                 -207                 4.9                 970               -119                 3.2
2002                                                    1,533                  102                 5.2                 947                -23                 3.1
2003                                                    1,476                  -57                 5.0                 933                -14                 3.0
2004                                                    1,426                  -50                 4.8                 854                -80                 2.7
2005                                                    1,425                    -1                4.7                 862                  8                 2.7

In 2005, the UK had one of the lowest rates of unemployment among the major developed nations. Although
the Netherlands and Ireland both have unemployment rates below that of the UK, we have one of the lowest
rates in the European Union. Indeed for the Euro Zone as a whole the rate of unemployment has been
persistently high in recent years – never lower than eight per cent and now rising to nearly nine per cent.
Unemployment is a major economic, social and political problem in countries such as Poland, Germany,
Spain and France – although the Spanish have succeeded in bringing their unemployment down from high
levels over the last few years.

                                                                                                                             - 63 -

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





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

                     Germany                United Kingdom             Ireland         Spain                   Italy
                                                                                                    Source: Reuters EcoWin

The main causes of unemployment

We now consider some of the main underlying causes of people being out of work

Frictional Unemployment

Frictional unemployment is transitional unemployment due to people moving between jobs:
For example, redundant workers or workers entering the labour market for the first time (such as university
graduates) may take time to find appropriate jobs at wage rates they are prepared to accept. Many are
unemployed for a short time whilst involved in job search. Imperfect information in the labour market may
make frictional unemployment worse if the jobless are unaware of the available jobs. Incentives problems
can also cause some frictional unemployment as some people actively looking for a new job may opt not to
accept paid employment if they believe the tax and benefit system will reduce the net increase in income
from taking work. When this happens there are disincentives for the unemployed to accept work.

Structural Unemployment

Structural unemployment occurs when there is a long run decline in demand in an industry leading to a
reduction in employment perhaps because of increasing international competition. Globalisation is a fact of
life – and inevitably it leads to changes in the patterns of trade between countries over time. Britain for
example has probably now lost for good, its cost advantage in manufacturing goods such as motor cars,
household goods and audio-visual equipment. Manufacturing industry has lost over 400,000 jobs in the last
five years alone. Many of these workers may suffer from a period of structural unemployment, particularly if
they are in regions of above-average unemployment rates where job opportunities are scarce. The decline in
manufacturing industry jobs is shown in the next chart.

                                                                                                                              - 64 -

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

                                        Employment in UK Manufacturing Industry
                                                           Millions, seasonally adjusted



      Persons (millions)






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

                                                                                                     Source: Reuters EcoWin

Structural unemployment exists where there is a mismatch between their skills and the requirements of the
new job opportunities. Many of the unemployed from manufacturing industry (e.g. in coal, steel and
engineering) have found it difficult to find new work without an investment in re-training. This problem is one
of occupational immobility of labour

Cyclical Unemployment:

Cyclical unemployment is involuntary unemployment due to a lack of demand for goods and services. This
is also known as Keynesian "demand deficient" unemployment. When there is a recession or a severe
slowdown in economic growth, we see a rising unemployment because of plant closures, business failures

                                                                                                                       - 65 -

and an increase in worker lay-offs and redundancies. This is due to a fall in demand leading to a contraction
in output across many industries. A downturn in demand is often the stimulus for businesses to rationalise
their operations by cutting employment in order to control costs and restore some of their lost profitability.

Cyclical unemployment and the output gap

                The relationship between national output and demand for labour – when there is an economic
                recession or slowdown in growth, the demand for labour may fall as businesses look to cut
                back on employment in order to control costs. The result is a fall in employment and a rise in
                cyclical unemployment. This will affect some industries more than others depending on how
                severe the recessionary effects are in a particular sector of the economy.

    Inflation                                      LRAS         Real Wage
                                                                     Level     Slowdown or recession in the economy
                                 Fall in AD causes a                           can lead to an inward shift in labour
                                 negative output gap                           demand and a fall in total employment
                                 – with GDP well
                                 below potential
                                                                                                    Supply of Labour

          P1                                                           W1


                                                                   AD1                                 LD2    Demand for

                                    Y2        Y1          Yfc                           E2    E1                YFC2

                                             Real National Income                                  Employment of Labour

Real wage unemployment:

This is considered to be the result of real wages being above their market clearing level leading to an excess
supply of labour. Some economists believe that the minimum wage risks creating unemployment in
industries where international competition from low-labour cost producers is severe. As yet, there is relatively
little evidence that the minimum wage has created rising unemployment on the scale that was feared.

Hidden unemployment

Undoubtedly there are thousands of people who by any reasonable definition are unemployed, but who are
not picked up by the official unemployment statistics. Many have become discouraged workers and have
stopped actively searching for work.

                                                                                                                      - 66 -

Unemployment and the production possibility frontier

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

  Output of Capital                                           If there are unemployed resources in the economy, this
                                                                   means that an economy will be operating within its
                                                                                         production possibility frontier.
                                                                  Unemployment represents a waste of scarce labour
                                                    B            resources and leads to output being below potential
                                                                   and a loss of allocative efficiency for the economy

                                                                                        If the economy is successful in
                                                                                reducing unemployment, then output
                                                                     A              of goods and services can move
                                                                                   closer to the frontier of the PPF –
                                                                                  e.g. towards combinations marked
                                                                                                by the letters A and B

                                                   X2           X1                                             Output of
                                                                                                         Consumer Goods

The economic and social costs of unemployment

High unemployment is widely recognised to create substantial costs for individuals and for the economy as a
whole. Some of these costs are difficult to measure, especially the longer-term social costs of a high level of
unemployment. Some of the costs are summarised below:
    1. Loss of income: Unemployment normally results in a loss of income. The majority of the
       unemployed experience a decline in their living standards and are worse off out of work
    2. Loss of national output: Unemployment involves a loss of potential national output (i.e. GDP
       operating below potential) and represents an inefficient use of scarce resources. If some people
       choose to leave the labour market permanently because they have lost the motivation to search for
       work, this can have a negative effect on long run aggregate supply (LRAS) and thereby damage
       the economy’s growth potential
    3. Fiscal costs: The government loses out because of a fall in tax revenues and higher spending
       on welfare payments for families with people out of work. The result can be an increase in the
       budget deficit which then increases the risk that the government will have to raise taxation or scale
       back plans for public spending on public and merit goods
    4. Social costs: Rising unemployment is linked to social deprivation. There is a relationship with
       crime, and social dislocation (increased divorce rates, worsening health and lower life expectancy).
       Areas of high unemployment see falling real incomes and a worsening in inequalities of income
       and wealth

                                                                                                          - 67 -

Government policies to reduce unemployment

Some countries are more successful than others in reducing the scale of unemployment. In the long term,
effective policies are required for both the demand and the supply side of the economy so that enough new
jobs are created and that people possess the skills and incentives to take those jobs.

In general the most effective policies are those that:
    1. Stimulate an improvement in the human capital of the workforce – so that more of the
       unemployed have the skills to take up the available jobs. Policies normally concentrate on improving
       the occupational mobility of labour. The pattern of employment in any modern economy is always
       changing, so people need to have sufficient flexibility to adapt to structural changes in industries
       over the years
    2. Improve incentives for people to search and then accept paid work – this may require reforms
       of the tax and benefits system for example a reduction in the starting rate of income tax (an incentive
       for people in lower paid jobs). Or perhaps a change in welfare benefits such that people who find
       work do not experience a sharp withdrawal of benefits because they are now earning more. The
       reality is that simply cutting welfare benefits across the board makes little difference to the
       unemployment figures – because of the complex nature of most unemployment. But targeted
       measures to improve incentives, including the linking of welfare benefits to participation in work
       experience programmes which is part of the New Deal programme or lower tax rates for people on
       low incomes might have an impact.
    3. Employment subsidies: Government subsidies for those firms that take on the long-term
       unemployed will create an incentive for businesses to increase the size of their workforce.
       Employment subsidies may also be available for overseas firms locating in the UK as part of the
       government’s regional policy. Labour’s New Deal programme works by offering subsidised jobs and
       training to the long-term unemployed. It differs from previous job creation schemes, in that people
       who refuse to comply can have their benefits stopped. According to the government's own figures,
       more than 40% of the jobs gained through the New Deal are short-term.
    4. Achieve a sustained period of economic growth – this requires that aggregate demand is
       sufficiently high for businesses to be looking to expand their workforce. The Keynesian theory of
       unemployment emphasises the argument that if monetary and fiscal policy does not keep demand at
       a high enough level, then the economy is less likely to be able to sustain a high rate of employment.
       However, not every increase in aggregate demand and production has to be met by employing more
       labour. Each year we expect to see a rise in labour productivity (more output per worker employed).
       And, businesses may decide to increase production by making greater use of capital inputs such as
       extra units of machinery. A growing economy creates jobs for people entering the labour market for
       the first time. And, it provides employment opportunities for people unemployed and looking for work.

Policies used in the UK to reduce unemployment

Demand side policies                                     Supply-side policies
Employment subsidies for employers who take on           Welfare reforms – including lower starting rates of
the long-term unemployed (New Deal)                      income tax and the introduction of tax credits
Financial assistance for inward investment from          Policies to promote entrepreneurship and the growth
overseas                                                 of small-medium size enterprises
Monetary policy – low interest rates has allowed         Increased spending on education and attempts to
aggregate demand to grow despite a global                increase private sector spending on training
economic slowdown. Fiscal policy is also boosting
AD as the budget deficit increases

Evaluation points on unemployment policies

    1. There are always cyclical fluctuations in employment. If growth can be sustained and monetary
       and fiscal policy can avoid a large negative output gap then it should be possible to create a steady
       flow of new jobs
    2. Demand and supply-side policies need to work in tandem for unemployment to fall in the long term.
       Simply boosting demand if the root cause of unemployment is structural is an ineffective way of

                                                                                                         - 68 -

       tackling the problem. If demand is stimulated too much, the main risk becomes one of rising inflation
       (i.e. the trade-off between these two objectives may worsen)
   3. Full-employment does not mean zero unemployment! There will always be some frictional
      unemployment – it may be useful to have a small surplus pool of labour available
   4. There are still large regional differences in unemployment levels and pockets of deep-rooted long-
      term unemployment in many areas, which causes significant economic and external costs

Recent trends in UK unemployment

The main explanation behind the decline in unemployment has been economic growth. Labour as a factor
input has a derived demand - so rising production generates a higher demand for labour. These
employment-creation effects have not been uniform throughout regions and industries.

Other factors that have helped bring down the unemployment rate include:
   1. Demographic factors – there has been a slower growth of the population of working age than at a
      similar stage of the last economic cycle in the early 1980s. This has lead to a slowdown in the
      numbers of people of working age entering the UK labour market.
   2. Expansion of further and higher education - there is a trend for more young people choosing to
      delay their entry into the labour market and remain in full-time post-16 further and higher education
      to boost their qualifications. Government policies have an explicit aim of increasing the participation
      rate of 18 year-olds in higher education. This puts less pressure on the number of new entrants into
      the labour force looking for work.
   3. "Discouraged worker effects" due to structural unemployment: Some workers have given up
      active job search, in the process become economically inactive and moved onto permanent sickness
      and invalidity benefits or early retirement. The precise number of people involved is difficult to
      calculate with accuracy – it probably affects several thousand people.
   4. Employment creation from foreign investment: The British economy has been successful in
      attracting billions of pounds worth of inward investment from overseas companies. A high proportion
      of this has gone into building new plants in the UK and this has created thousands of new jobs
      helping to offset some of the regional disparities in unemployment.
   5. Increased investment in worker training: This seems to have reduced structural unemployment.
      Labour shortages are problematic in some industries, notably in areas where house prices are high
      and unemployment rates have fallen below 2%. But taking the economy as a whole, it seems that
      shortages of labour have not proved to be as difficult as in previous phases of economic expansion.
      The main shortages are in highly skilled jobs and in areas where living costs are well above the
      national average. The government has suffered from a shortage of workers in key public sector jobs.
   6. Increased flexibility in the labour market: This has made it easier for businesses to hire workers
      and match their desired labour input to planned production. The number of part-time workers on
      short-term contracts has grown by many thousands. There has also been greater functional flexibility
      with workers expected to perform a number of tasks within the business.

Can the UK achieve full-employment?

The British labour market has performed well in the last decade raising hopes that low unemployment be
maintained for the foreseeable future. There is still much to be done to reduce unemployment in
economically depressed areas. Although the average rate of unemployment has come down, jobless rates in
excess of 10% are a feature of many towns and cities. And youth unemployment remains a serious
problem. The sustained fall in unemployment has encouraged optimism that Britain can reach full-
employment in the near future. Indeed, in some regions and towns and cities, full-employment is already a
reality. The UK unemployment rate started to rise again in 2005 and 2006 albeit at a gentle rate.

Economists agree that unemployment cannot fall to zero since there will always be frictional
unemployment caused by people moving into the labour market and others switching between jobs. Full-
employment might be defined as when the labour market has reached a state of equilibrium - i.e. when
those who are willing and able to work at going wage rates are able to find work.

                                                                                                           - 69 -

Another interpretation of full-employment is when the total of people out of work matches the number of
unfilled job vacancies. The problem with this is that estimates of the scale of job vacancies vary
considerably. The true number of jobs available is probably three times the official published figure.

Skills Shortages

The prospect of reaching full-employment is diminished by the continuing problem of skills shortages. Skills
shortages have been a recurrent problem in manufacturing jobs, but the problem has widened to new
economy businesses and also the public services (including education and the NHS)

Closing the skills gap

Literacy, numeracy and skills levels in the UK are so poor that a quarter of employers struggle to fill job
vacancies. A study by the national Skills Task Force backs up previous research by suggesting that nearly
one in five adults - about seven million - have a lower level of literacy than the average 11 year old. Because
of skills shortages, employers are lowering their expectations when recruiting people and cutting back on
capacity and quality level. The report finds that a quarter of adults are "functionally innumerate", and that one
in three have less than five GCSE exam-passes. And it says employers believe almost two million of their
staff is not fully proficient at their jobs

                                                                   Adapted from news reports on the Skills Gap

                                                                                                         - 70 -

    15. International Trade

We now consider the impact that trade has on our economic performance. Britain is a highly ‘open
economy’. This means that a large and rising share of our output of goods and services is tied to trade with
other countries around the world.

The British economy is sensitive to fluctuations in the global economic cycle and also changes in the
exchange rate. No economist can afford to ignore the effects that international trade and the free flow of
financial capital has both on the demand and supply-side of the economy.

The pattern of merchandise trade (trade in goods for the UK)

Breakdown in economy's total exports                       Breakdown in economy's total imports
 By main commodity group                                    By main commodity group
                  Agricultural products           5.8                        Agricultural products            9.9
                       Mining products           10.4                             Mining products             8.9
                         Manufactures            82.6                               Manufactures             80.4

 By main destination                                        By main origin
               1. European Union (15)            55.8                        1. European Union (15)          50.2
                      2. United States           14.9                               2. United States         11.4
                              3. Japan            1.9                                       3. Japan          3.6
                        4. Switzerland            1.7                                       4. China          3.0

                                Source: World Trade Organisation International Trade Statistics

The Advantages of International Trade
    o   Financing our imports: Britain needs to export goods and services to finance imports of products
        we cannot supply in this country. Exports represent an injection of demand into the circular flow of
        income and therefore create growth potential for many industries as businesses look to expand
        beyond the confines of their domestic (national) boundaries).
    o   Improving consumer welfare: There is a potential improvement in economic welfare if countries
        specialize in the products in which they have a comparative advantage and then trade with other
        nations. Trade between nations also provides greater choice for consumers and competition helps
        keep prices down
    o   Exploiting economies of scale: Trade allows firms to exploit economies of scale by operating in
        larger markets – for example, the EU has over 450 million consumers with a massive purchasing
        power and this is set to grow further now that the European Union has enlarged with the addition of
        ten new member countries. Economies of scale lead to lower average costs – a gain in efficiency
        that might be passed onto consumers through lower prices
    o   Increased efficiency: International competition stimulates higher allocative and productive
        efficiency. Trade in ideas stimulates product and process innovations that generates better products

                                                                                                                                          - 71 -

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

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












                         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
The World Trade Organization (WTO)

The World Trade Organisation helps to promote free trade by persuading countries to abolish import tariffs
and other barriers to open markets. The WTO was established in 1995 and was preceded by another
international organization known as the General Agreement on Tariffs and Trade (GATT). Membership of
the WTO has expanded to over 140 countries – with the recent successful admission of China to the WTO
ranking as an event of potentially huge significance. It has evolved into a complex web of agreements
covering everything from farm goods and textiles to banking and intellectual property. The WTO oversees
the rules of international trade. It helps to settle trade disputes between governments, for example the
recent dispute between the United States and Europe over the introduction of tariffs by the USA on imported
steel. Increasingly, the global economy is being concentrated into trading blocs where free trade is
encouraged within each bloc, but import controls are established for products entering a trade bloc.

Import Controls

Import controls are defined as any barriers to the free movement of goods and services that seek to
distort the pattern of trade between countries.

(a) Tariffs:

A tariff is a tax on imports and is used to restrict the demand for imports and at the same time raise revenue
for the government. The effects of the import tariff depend on the price elasticity of demand of home-based
consumers and the price elasticity of supply of domestic producers. A tariff will have a greater effect the
more elastic the demand and supply. If the demand is inelastic then the imposition of a tariff will have little
effect on the level of imports. The introduction of tariffs by one country can lead to retaliation responses
from other countries. This retaliation can lead to damaging trade-wars.

(b) Import Quotas

An import quota directly reduces the quantity of a product that is imported and indirectly reduces the
amount of money that the export producers receive. The main beneficiaries of quotas are the domestic
producers who then face less competition in their respective markets.

                                                                                                          - 72 -

(c) Export Subsidy

An export subsidy is a payment to a domestic producer who exports a good abroad. If receiving an export
subsidy, a firm can remain competitive abroad by exporting up to the foreign price (because the subsidy will
cover some of the difference) yet receive the higher price domestically. The effects of a subsidy are the
opposite of those of a tariff. Export subsidies are controversial.

A high profile example is the export refund system used by the EU as part of the Common Agricultural
Policy (CAP). It is argued that export refunds for European farmers undermines the domestic agricultural
industries of developing countries and distorts the fundamental principles of free trade.

Economic Case for Import Controls
    1. Infant Industry Argument: Certain industries possess a potential comparative advantage but have
       not yet exploited potential economies of scale. Short-term protection from foreign competition allows
       the industry to develop its comparative advantage. The danger is that the industry, free of the
       disciplines of competition, will never achieve full efficiency.
    2. Protection against “dumping”: Dumping' refers to the sale of a good below its cost of production.
       In the short term, consumers benefit from the low prices of the foreign goods, but in the longer term,
       undercutting of domestic prices will force the domestic industry out of business and allow the foreign
       firm to establish itself as a monopoly.
    3. Externalities and Import Controls: Protectionism can deal with de-merit goods such as alcohol,
       tobacco and narcotic drugs that have adverse social effects.
   4. Non Economic Reasons for Protectionism: Countries may wish not to over-specialize in the
       goods in which they possess a comparative advantage. One of the potential dangers of over-
       specialisation is that unemployment may rise quickly if an industry moves into structural decline as
       new international competition emerges at lower costs.
Problems with Import Protection
    1. A loss of efficiency and welfare: Trade barriers restrict competition leading to a loss of economic
       welfare and increased inefficiency because of higher prices and less consumer choice
    2. Disincentive to innovate: Firms that are protected from competition have little incentive to reduce
       production costs. These disadvantages must be considered carefully by governments
    3. Risks of retaliation: There is the danger that one country imposing import controls will lead to
       retaliatory action by another leading to a decrease in the volume of world trade

                                                                                                         - 73 -

    16. Balance of Payments

The balance of payments provides us with important information about whether or not a country is “paying its
way” in the international economy.

What is the Balance of Payments?

The balance of payments (BOP) records all of the many financial transactions that are made between
consumers, businesses and the government in the UK with people across the rest of the World. The BOP
figures tell us about how much is being spent by British consumers and firms on imported goods and
services, and how successful UK firms have been in exporting to other countries and markets. It is an
important measure of the relative performance of the UK in the global economy. At AS level we focus only on
one part of the balance of payments accounts. This section is known as the current account. We will go
through the make-up of this account in a later section.

Why is the export sector of the economy vital for the UK?
    1. Aggregate demand and the multiplier: An increasing share of Britain’s national output is exported
       overseas as the nation becomes ever more integrated into the global economy. Export earnings are
       an injection of AD into the circular flow. If British companies can successfully sell more goods and
       services overseas, the rise in exports boosts national income and should have a positive multiplier
       effect on the national income, output and employment.
    2. Manufacturing industry: Export sales are particularly important for manufacturing industry where
       exports are a high % of total production. Thousands of jobs depend directly on the performance of
       the export sector and even more are affected in supply industries. Select this link for more articles on
       British manufacturing industry
    3. Regional economic health: The relative success of failure of export industries is important for
       certain regions of the UK. When export sales dip (for example as a result of a global downturn or the
       impact of the strong exchange rate), output, employment and living standards come under threat and
       threaten to widen the existing north-south divide.

Trade in goods includes items such as:                  Trade in services includes:
        Manufactured goods                                      Banking,      insurance  and    consultancy
        Semi-finished goods and components                      services
        Energy products                                         Other financial services including foreign
        Raw Materials                                           exchange and derivatives trading
        Consumer goods                                          Tourism industry
        (i) Durable goods e.g. DVD recorder and                 Transport and shipping
        new cars                                                Education and health services
        (ii) Non-durable goods e.g. foods and                   Services associated with research and
        beverages                                               development
        Capital goods (e.g. new plant and                       Cultural arts

Trade in goods

Trade in goods includes exports and imports of oil and other energy products, manufactured goods,
foodstuffs, raw materials and components. Until recently this was known as visible trade – i.e. exporting and
importing of tangible products. Since 1986 the net balance of trade in goods for the UK has been in deficit.
And as the following chart shows, the trade deficit in goods has increased enormously in the last few years.
In 2005 there was a record trade deficit of £66 billion, over three times the deficit seen in 1998.

                                                                                                                                                        - 74 -

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


      GBP (billions)





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

                                                                                                                               Source: Reuters EcoWin
Trade in services

Overseas trade in services includes the exporting and importing of intangible products – for example,
Banking and Finance, Insurance, Shipping, Air Travel, Tourism and Consultancy. Britain has a strong trade
base in services with over thirty per cent of total export earnings come from services.

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




      GBP (billions)







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

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

                                                                                                         - 75 -

from the effects of Hurricane Katrina in the United States. Strong surpluses are especially common in
financial and business services and hi-tech knowledge services.

But the UK runs a deficit in international travel and transportation in part because of the growth of demand
for overseas holidays as living standards have improved. Once again, rising incomes have caused a large
rise in the demand for overseas leisure and business travel and the sustained strength of the exchange rate
against most European currencies and the rapid expansion of low cost airlines offering short haul overseas
breaks has also played its part.

Britain has a comparative advantage in selling financial services to the rest of the world. London is one of
the three main financial centres in the world and has the largest share of trading in many international
financial markets. Many overseas banks have established themselves in London’s money and capital
markets. And numerous British financial businesses have world class status in their areas of expertise. Our
UK based commercial banks, fund managers, securities dealers, futures and options traders, insurance
companies and money market brokerage businesses are part of a complex network of financial and business
services that represent a huge asset for the UK balance of payments accounts.

Measuring the current account

The current account balance comprises the balance of trade in goods and services plus net investment
incomes from overseas assets. Net investment income arises from interest payments, profits and dividends
from external assets located outside the UK. We also add in the net balance of private transfers between
countries and government transfers (e.g. UK government payments to help fund the various spending
programmes of the European Union).

The net investment income flow for the UK is positive – a reflection of the heavy investment overseas in
recent years by British businesses and individuals. The transfer balance is negative – one reason is that the
British government is a net contributor to the EU budget.

The current account of the balance of payments

The current account balance is essentially a reflection of whether the British economy is paying its way with
other countries. The annual balance is volatile from year to year, because each of the four component parts
is subject to wide fluctuations.

                  Balance of        Balance of          Net Investment      Current           Current
                  trade in goods    trade in            Income              transfers         account
                                    services                                                  balance
                  £ billion         £ billion           £ billion          £ billion          £ billion
1996              -13.7             11.2                0.6                -4.8               -6.7
1997              -12.3             14.1                3.3                -5.9               -0.8
1998              -21.8             14.7                12.3               -8.4               -3.2
1999              -29.1             13.6                1.3                -7.5               -21.7
2000              -33.0             13.6                4.5                -10.0              -24.8
2001              -41.2             14.4                11.7               -6.8               -21.9
2002              -47.7             16.8                23.4               -9.1               -16.5
2003              -48.6             19.2                24.6               -10.1              -14.9
2004              -60.9             25.9                26.6               -10.9              -19.3
2005              -67.3             17.9                29.9               -12.2              -26.6
                                                                          Source: Office of National Statistics

What are the main questions that concern economists regarding these figures?
    i    Causation: Why does the UK now run such large trade deficits in goods?
    ii   Consequences: Does it really matter if the British economy is running persistent current account
    iii Correction: Which demand and supply-side economic policies are likely to be most effective in
         improving our trade balances in the years ahead?

                                                                                                            - 76 -

The underlying causes of the UK trade deficit

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

Short-term factors
    i    Strong consumer demand: Real household spending has grown more quickly than the supply-side
         of the economy can deliver, leading to a very high level of demand for imported goods and services
    ii   High income elasticity of demand for imports: Evidence suggests that UK consumers have a
         high income elasticity of demand for overseas-produced goods – demand for imports grows quickly
         when consumer demand is robust. Nicholas Fawcett and Michael Kitson in a recent article in the
         Guardian estimated that the income elasticity is around +2.3 suggesting that a 2% increase in real
         incomes boosts demand for imports by 4.6%. Because the overseas demand for UK exports rarely
         keeps pace with the surging demand for imported products, so the trade deficit widens when the
         economy enjoys a period of consumption-led growth.
    iii The strong exchange rate has helped to reduce the UK price of imports causing an expenditure-
         switching effect away from domestically produced output.
    iv The weakness of the global economy and in particular the slow growth in the Euro Zone has
         damaged UK export growth. Nearly 60% of UK manufactured goods exports and over 50% of our
         exports of services are to fellow members of the European Union.

Medium-term factors
    i    UK trade balances have been affected by shifts in comparative advantage in the international
         economy – for example the rapid growth of China as a source of exports of household goods and
         other countries in South-east Asia who have a cost advantage in exporting manufactured products
    ii   The availability of imports from other countries at a relatively lower price inevitably causes a
         substitution effect from British consumers.

Longer-term factors
    i    Much of our trade deficit is due to structural rather than cyclical factors
    ii   Our trade performance has been hindered by supply-side deficiencies which impact on the price
         and non-price competitiveness of British products in global markets - non-price competitiveness
         factors such as design and product quality are now more important for trade than merely price alone.
             o   A relatively low rate of capital investment compared to other countries
             o   The persistence of a productivity gap with our major competitors – measured by
                 differences in GDP per person employed or per hour worked – this is linked to low
                 investment and also to the existence of a skills-gap between UK workers and employees in
                 many other countries
             o   A relatively weak performance in terms of product innovation – linked to a low rate of
                 business sector spending on research and development
    iii The UK manufacturing sector has been in long-term decline for more than twenty years. This is
         known as a process of deindustrialisation. Although we still have some world class manufacturing
         companies, the size of our manufacturing sector is not large enough both to meet consumer demand
         in the UK and also to export sufficient volumes of products to pay for a growing demand for imports

What does a current account deficit mean?

Running a sizeable deficit on the current account basically means that the UK economy is not paying its way
in the global economy. There is a net outflow of demand and income from the circular flow of income and
spending. The current account does not have to balance because the balance of payments also includes
the capital account. The capital account tracks capital flows in and out of the UK. This includes portfolio
capital flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows
arising from foreign investment.

The Effects of Changes in the Balance of Payments on the UK Economy

                                                                                                           - 77 -

Consider the effects of a slowdown in exports and a faster growth in imports of goods and services caused
by a rise in the value of sterling against other currencies that leads to a worsening of the balance of
payments. This has further effects on the economy as a whole:

    o   Reductions in demand in the circular flow: There will be a net fall in AD because more money is
        leaving the circular flow of income (through imports) than is coming in from exports. An inward shift
        of AD would lead to a contraction along the SRAS curve.
    o   Lost jobs: There will be a loss of employment if exporting industries require less labour and if UK
        businesses lose market share and output to cheaper imports from overseas.
    o   Dip in business confidence and investment: A fall in business confidence and a decline in capital
        investment spending by UK exporting firms whose order books are less full and whose profits take a
        hit from a fall in demand from overseas.
    o   Reductions in inflationary pressure: Lower inflation because imports coming into the UK are
        cheaper and a fall in AD takes the economy further away from full capacity. Reduced inflationary
        pressure might then persuade the Bank of England to reduce interest rates to provide a boost to
        macroeconomic activity.

The exchange rate and the balance of payments

Changes in the exchange rate can have a big effect on the balance of payments although these effects are
subject to uncertain time lags. When sterling is strong then UK exporters found it harder to sell their products
overseas and it is cheaper for UK consumers to buy imported goods and services because the pound buys
more foreign currency than it did before.

The Balance of Payments and the Standard of Living

A common misconception is that balance of payments deficits are always bad for the economy. This is not
necessarily true. In the short term if a country is importing a high volume of goods and services this is a
boost to living standards because it allows consumers to buy more consumer durables. However, in the long
term if the trade deficit is a symptom of a weak economy and a lack of competitiveness then living standards
may decline.

                                                                                                          - 78 -

    17. Government Macroeconomic Policy

In this chapter we consider the ways in which government economic policies can be used to achieve aims
such as low inflation, stable growth and high levels of employment.

Is there a need for macroeconomic policy?

A central issue in macroeconomics is whether or not markets, left alone, automatically bring about long run
economic equilibrium. If the free operation of market forces eventually resulted in a full employment level of
national income with stable prices and economic growth, there would be no need for government
intervention in the macro economy - no need for fiscal monetary exchange rate and supply side policies. The
reality is that all governments intervene through their macroeconomic policies in a bid to achieve certain
policy objectives and improve the overall performance of the economy.

Main Objectives of Government Economic Policy
    1. Sustained economic growth
    2. Stable prices (low inflation)
    3. A high level of employment
    4. A rise in average living standards
    5. Sustainable position on the balance of payments
    6. Sound government finances

Demand Management

Demand management occurs when the government attempts to influence the level and growth of AD hence
the levels of national income, employment, rate of inflation, growth and the balance of payments position
    1. Reflationary policies seek to increase AD and raise the level of planned expenditure at or near the
       level of potential GDP
    2. Deflationary policies decrease AD in the event of aggregate demand running ahead of AS and
       posing inflationary risks or leading to an unsustainable deficit on the balance of payments

We will focus on fiscal and monetary policies as the main instruments of demand management

The Main Problems of Managing the Macroeconomy

The government’s task of managing the economy is made difficult by several factors some of which are
discussed below:
    1. Inaccurate economic data: All of the main macroeconomic indicators are subject to a margin of
       error. They rely on statistical data collected from tax returns and surveys and data is often revised
       many months after its first release
    2. Conflicting policy objectives: A policy of stimulating aggregate demand may reduce
       unemployment in the short term but initiate a period of higher inflation and exacerbate the current
       account of the balance of payments. Choices have to be made between objectives i.e. there exist
       trade-offs between them
    3. Selecting the right policy instrument: Each macroeconomic objective requires a separate policy
       instrument: The usual ‘rule of thumb’ is that one main policy instrument should be assigned to one
       policy objective. So, for example, interest rates might be assigned as the main instrument for
       keeping control of inflation, whilst fiscal policy instruments such as changes to the tax system might
       be allocated to achieving some supply-side objectives such as increasing the labour supply, boosting
       incentives, raising investment and increasing productivity. There are quite deep-rooted
       disagreements between some economists (who belong to different ‘schools of thought’) as to which
       policies are most effective to meet a certain objective
    4. Uncertain time lags when running a policy: Changes in economic policies are subject to uncertain
       time lags e.g. a change in interest rates is estimated to take some 18-24 months to work its way fully

                                                                                                           - 79 -

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

Changes in direct and indirect taxes have an impact on people’s disposable incomes – this feeds through to
                     the wider economy and affects demand, growth and employment

The main policies of economic management

    •   Fiscal Policy

            o   Fiscal policy involves the use of government spending, taxation and borrowing to influence
                both the pattern of economic activity and also the level and growth of aggregate demand,
                output and employment.

    •   Monetary Policy

            o   Monetary policy involves the use of interest rates to control the level and rate of growth of
                aggregate demand in the economy.

The Bank of England is charged with the task of 'maintaining the integrity and value of the currency'. The
Bank pursues this objective through the use of monetary policy. Above all, this involves maintaining price
stability, as defined by the inflation target set by the Government, as a precondition for achieving a wider
goal of sustainable economic growth and high employment. Since 1997, the BoE has had operational
independence in the setting of interest rates. The Bank aims to meet the Government's inflation target -
currently 2.0 per cent for the consumer price index- by setting short-term interest rates. Interest rate
decisions are taken by the Monetary Policy Committee (MPC) at their monthly meetings.

Monetary policy also involves the effects of changes in the exchange rate – the external value of one
currency against another – on the wider economy

Supply-side Policies

Supply-side economic policies are mainly micro-economic policies designed to improve the supply-side
potential of an economy, make markets and industries operate more efficiently and thereby contribute to a
faster rate of growth of real national output. Most governments now accept that an improved supply-side
performance is the key to achieving sustained economic growth without a rise in inflation. But supply-side
reform on its own is not enough to achieve this growth. There must also be a high enough level of aggregate
demand so that the productive capacity of an economy is actually brought into play.

                                                                                                            - 80 -

There are two broad approaches to the supply-side. Firstly policies focused on product markets where
goods and services are produced and sold to consumers and secondly supply-side policies applied to the
labour market – a factor market where labour is bought and sold.

The effects of Monetary and Fiscal Policy on the economy

There are some differences in the economic effects of monetary and fiscal policy, on the composition of
output, the effectiveness of the two kinds of policy in meeting the government’s macroeconomic objectives,
and also the time lags involved for fiscal and monetary policy changes to take effect. We will consider each
of these in turn:

Effects of Policy on the Composition of National Output

Monetary policy is often seen as something of a blunt policy instrument – affecting all sectors of the
economy although in different ways and with a variable impact.

In contrast, fiscal policy can be targeted to affect certain groups (e.g. increases in means-tested benefits for
low income households, reductions in the rate of corporation tax for small-medium sized enterprises,
investment allowances for businesses in certain regions)

Consider as an example the effects of using either monetary or fiscal policy to achieve a given increase in
national income because actual GDP lies below potential GDP (i.e. there is a negative output gap)

        (i) Monetary policy expansion

        Lower interest rates will lead to an increase in consumer and business capital spending both of
        which increases national income. Since investment spending results in a larger capital stock, then
        incomes in the future will also be higher through the impact on LRAS.

        (ii) Fiscal policy expansion

        An expansion in fiscal policy (i.e. an increase in government spending) adds directly to AD but if
        financed by higher government borrowing, this may result in higher interest rates and lower
        investment. The net result (by adjusting the increase in G) is the same increase in current income.
        However, since investment spending is lower, the capital stock is lower than it would have been, so
        that future incomes are lower.

Time Lags of Monetary and Fiscal Policies

Monetary and fiscal policies differ in the speed with which each takes effect

Monetary policy in the UK is flexible (interest rates can be changed each month) and emergency rate
changes can be made in between meetings of the MPC, whereas changes in taxation take longer to
organize and implement. Because capital investment requires planning for the future, it may take some time
before decreases in interest rates are translated into increased investment spending. Typically it takes six
months – twelve months or more before the effects of changes in UK monetary policy are felt.

The impact of increased government spending is felt as soon as the spending takes place and cuts in direct
and indirect taxation feed through into the economy pretty quickly. However, considerable time may pass
between the decision to adopt a government spending programme and its implementation. In recent years,
the government has undershot on its planned spending, partly because of problems in attracting sufficient
extra staff into key public services such as transport, education and health.

                                                                                                             - 81 -

    18. Monetary Policy

Monetary policy influences the decisions that we make about how much we save, borrow and spend.

What is Money?

Money is defined as any asset that is acceptable as a medium of exchange in payment for goods and
services. The main functions of money are as follows:
    1. A medium of exchange used in payment for goods and services
    2. A unit of account used to relative measure prices and draw up accounts
    3. A standard of deferred payment – for example when using credit to purchase goods and services
       now but pay for them later
    4. A store of value - money holds its value fairly well unless there is a situation of accelerating
       inflation. As the general price level in the economy rises, so the internal value of a unit of currency

Interest Rates

There is no unique rate of interest in the economy. For example we distinguish between savings rates and
borrowing rates. However interest rates tend to move in the same direction. For example if the Bank of
England cuts the base rate of interest then we expect to see lower mortgage rates and lower rates on
savings accounts with Banks and Building Societies.

The Real Rate of Interest

The real rate of interest is often important to businesses and consumers when making spending and saving
decisions. The real rate of return on savings, for example, is the money rate of interest minus the rate of
inflation. So if a saver is receiving a money rate of interest of 6% on his savings, but price inflation is running
at 3% per year, the real rate of return on these savings is only + 3%.

The Job of Monetary Policy

“…to deliver price stability (as defined by the Government’s inflation target) and, subject to this objective, to
support the Government’s economic policy, including its objectives for economic growth and employment…”

The Bank of England has been independent since 1997. In that time there has been a cycle of small
changes in interest rates. They have varied from 3.75% (in the late autumn of 2003) to 7.5% in the autumn of
1997. Generally though, the UK economy has experienced a sustained period of low interest rates over
recent years. And, this has had important effects on the wider economy.

The Bank of England prefers a gradualist approach to monetary policy – believing that a series of small
movements in interest rates is a more effective strategy rather than sharp jumps in the cost of borrowing
money. Their aim is not to shock consumers and businesses to control their spending, but to gradually
increase the cost of borrowing money and increase the incentive to save, so that the pace of growth
moderates and the economy can continue to grow without causing rising inflation.

Factors considered when setting interest rates
    1. The State of Demand: Is aggregate demand too strong – for example is household spending
       booming at an unsustainable rate?
    2. The Housing Market: What are the economic signals coming from the housing market? If house
       prices rising too strongly, this might feed through into increased consumer demand and the risk of a
       surge in demand-pull inflation.
    3. The Labour Market: Are their inflationary signals coming from the labour market in the form of
       acceleration in wages and average earnings well above the growth of labour productivity?
    4. Inflation from overseas: Is there a risk from import costs such as a rise in oil prices?

                                                                                                                        - 82 -

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

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

Interest rate changes since 1997

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








                      97   98         99        00         01          02       03        04            05     06

                                                                                               Source: Reuters EcoWin

Effects of Changes in Interest Rates

There are several ways in which changes in interest rates influence aggregate demand. These are
collectively known as the transmission mechanism of monetary policy.

One of the principal channels that the MPC can use to influence aggregate demand, and therefore inflation,
is via the lending and borrowing rates charged by the market.

When the Bank’s base interest rate rises, banks will typically increase both the rates that they charge on
loans, and the interest that they offer on savings. This tends to discourage businesses from taking out loans
to finance investment and encourages the consumer to save rather than spend — and so depresses
aggregate demand. Conversely, when the base rate falls, banks tend to cut the market rates offered on
loans and savings. This will tend to stimulate aggregate demand.

Changes to the level of interest rates take time to have an impact on overall economic activity - i.e. there is a
time lag involved. A change in interest rates can have wide-ranging effects on the economy.

                                                                                                             - 83 -

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

                      Market interest rates
                 E.g. savings rates & credit cards
                                                       I.e. C + I + G

                           Asset prices                                     Demand                 Domestic
                         E.g. house prices                                     AD                Inflationary
                                                                        Drives short-term          Pressure
                                                                            economic             i.e. changes
 Official Interest                                                                            in the output gap
       Rate                                                                                 (actual GDP relative
 Set by the MPC                                                                               to potential GDP)
                        Expectations and                i.e. X - M
                     Businesses & consumers


                                                                                             Consumer Price
                          Exchange rate

The Bank’s view of the transmission mechanism resulting from a change in official base interest rates is
shown in the flow chart above – the key to it is that short-term changes in interest rates feed through fairly
quickly to the rest of the UK financial system (e.g. resulting in changes in mortgage interest rates, rates of
interest on savings accounts and also credit card rates) and then start to influence the spending and savings
decisions of millions of households and businesses.

A key influence played by rate changes is the effect on confidence – in particular household’s confidence
about their own personal financial circumstances.
    1. Housing market & house prices: Higher interest rates increase the cost of mortgages and
       eventually reduce the demand for most types of housing. This will slow down the growth of
       household wealth and put a squeeze on equity withdrawal (consumers borrowing off the back of
       rising house prices) which adds directly to consumer spending and can fuel inflation
    2. Effective disposable incomes of mortgage payers: If interest rates increase, the income of
       homeowners who have variable-rate mortgages will fall – leading to a decline in their effective
       purchasing power. The effects of a rate change are greater when the level of existing mortgage debt
       is high, leading to a rise in debt-servicing burdens for home-owners. On the other hand, a rise in
       interest rates boosts the disposable income of people who have paid off their mortgage and who
       have positive net savings in bank and building society accounts.
    3. Consumer demand for credit: Higher interest rates increase the cost of servicing debt on credit
       cards and should lead to a deceleration in the growth of retail sales and spending on consumer
       durables. Much depends on the impact of a rate change on consumer confidence.
    4. Business capital investment: Firms often take the actual and expected level of interest rates into
       account when deciding whether or not to proceed with new capital investment spending. A rise in
       short term rates may dampen business confidence and lead to a reduction in planned capital
       investment. However, many factors influence investment decisions other than rate changes.
    5. Consumer and business confidence: The relationship between interest rates and business and
       consumer confidence is complex, and depends crucially on prevailing economic conditions. For
       example, when businesses and consumers are worried about the risk of a recession, an interest rate
       cut can boost confidence (and therefore aggregate demand) because it reassures the public that the
       Bank is alert to the dangers of an economic slump. There are circumstances, however, where a cut

                                                                                                            - 84 -

        in rates could undermine confidence. For example, were the Bank of England to cut interest rates
        too quickly, the fear might be that the Bank is particularly worried about the prospects of a recession.
        The setting of interest rates nearly always calls for a finely balanced judgement, particularly when
        the effects on consumer and business confidence are concerned.
    6. Interest rates and the exchange rate: Higher UK interest rates might lead to an appreciation of the
       sterling exchange rate particularly if UK interest rates rise relative to those in the Euro Zone and the
       United States attracting inflows of “hot money” into the British financial system. A stronger exchange
       rate reduces the competitiveness of UK exports in overseas markets because it makes our exports
       appear more expensive when priced in a foreign currency (leading to a decline in export volumes
       and market share). It also reduces the sterling price of imported goods and services leading to lower
       prices and rising import penetration. If the trade deficit in goods and services widens, this is a net
       withdrawal of demand from the circular flow and acts to reduce excess demand in the economy.

Usually a UK interest rate cut will tend to weaken the pound as it makes it less attractive for foreign investors
to hold their money in Britain.

When the pound rises, British exports become more expensive, while imported goods from abroad become
cheaper. So a rising pound leads to a fall in demand for UK exports and a fall in demand for domestically
produced goods that compete with imports from overseas. A rising pound therefore reduces aggregate
demand, and so can dampen down the rate of inflation. An increase in the pound also affects the inflation
rate directly by bringing down the price of imported goods.

Monetary Policy Asymmetry

Fluctuations in interest rates do not have a uniform impact on the economy. Some industries are more
affected by interest rate changes than others (for example exporters and industries connected to the housing
market). And, some regions of the British economy are also more exposed (sensitive) to a change in the
direction of interest rates.

The markets that are most affected by changes in interest rates are those where demand is interest elastic
in other words, market demand responds elastically to a change in interest rates (or indirectly through
changes in the exchange rate).

Good examples of interest-sensitive industries include those directly linked to demand conditions in the
housing market¸ exporters of manufactured goods, the construction industry and leisure services. In contrast,
the demand for basic foods and utilities is less affected by short term fluctuations in interest rates.

The rate of interest is under the control of the Bank of England, but most other economic variables are not!
The MPC’s decisions can influence consumer and business behaviour but it cannot determine directly the
rate of inflation.

                                                                                                                 - 85 -

    19. The Exchange Rate

This chapter looks at the currency markets where the value of one currency against another is determined
on a daily basis

    •    The exchange rate measures the external value of sterling in terms of how much of another
         currency it can buy. For example - how many dollars or Euros you can buy with £5000.

    •    The daily value of the currency is determined in the foreign exchange markets (FOREX) where
         billions of $s of currencies are traded every hour.

    •    The global currency markets are open 24 hours a day allowing businesses, banks, individuals to
         trade in the currencies that they need.

Recent trends in the exchange rate

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







                  90          92        94        96          98         00     02        04          06
                                                                                        Source: Reuters EcoWin

The UK operates with a floating exchange rate system where the forces of market demand and supply for
a currency determine the daily value of one currency against another. If, for example, overseas investors
want to buy into sterling to take advantage of higher interest rates on offer in UK bank accounts, they will
swap their own currencies for pounds. This causes an increase in the demand for sterling in the foreign
exchange markets, and in the absence of other offsetting factors, this will force sterling higher against other

How does a change in the exchange rate influence the economy?

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

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

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

                                                                                                                        - 86 -

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

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




      £ per $1






                         00      01             02              03              04              05            06

                                                                                               Source: Reuters EcoWin

Advantages of an appreciation in the currency

   1. Cheaper imports for consumers: A high pound leads to lower import prices – this boosts the real
      living standards of consumers at least in the short run – for example an increase in the real
      purchasing power of UK residents when travelling overseas or the chance to buy cheaper computers
      or motor vehicles from the United States or Europe.

   2. Lower costs for producers: When the sterling exchange rate is high, it is cheaper to import raw
      materials, component parts and capital inputs such as plant and equipment – this is good news for
      businesses that rely on imported components or who are wishing to increase their investment of new
      technology from overseas countries. A fall in import prices has the effect of causing an outward shift
      in the short run aggregate supply curve. And if a country can now import more productive
      technology, the LRAS curve may shift out.

   3. Lower inflation: A strong exchange rate helps to control the rate inflation because domestic
      suppliers now face stiffer international competition from cheaper imports and will look to cut their
      costs and prices accordingly in order not to suffer from a loss of international competitiveness.
      Cheaper prices of imported foodstuffs and beverages will also have a negative effect on the rate of
      consumer price inflation.

   4. If inflation is lower, then interest rates will be lower than if the exchange rate was weaker – and
      cheaper money will eventually stimulate higher consumer spending and capital spending in the
      circular flow

Disadvantages of a Strong Pound

   1. Increase in the trade deficit: The lower price of imports leads to consumers increasing their
      demand and this can cause a large trade deficit. Exporters lose price competitiveness because
      they will find it more expensive to sell in foreign markets and face losing market share – this can
      damage profits and employment in some sectors and industries.

                                                                                                                     - 87 -

    2. Slower economic growth: If exports fall, this causes a reduction in aggregate demand and reduces
       the short-term rate economic growth as measured by the % change in real GDP. Some regions of
       the economy are affected by this more than others. In the North east for example, manufacturing
       industry accounts for over 28% of regional GDP whereas the percentage for the UK as a whole is
       just 19%.

    3. If exports fall, then so will business confidence and capital investment – because investment is
       partly dependent on the strength of demand

Showing the effects of currency movements using AD-AS analysis

Inflation                                             Inflation
                                          LRAS                                                        LRAS

                                 AD2                                                         AD

                           Y2      Y1            Real National                      Y1 Y2                Real National
                                                 Output                                                  Output

                    A fall in export demand                          A fall in the cost of importing raw materials
              Lower GDP level – negative output gap                    Increase in GDP – reduction in inflation

Changes in the exchange rate have quite a powerful effect on the economy but we tend to assume ceteris
paribus – all other factors held constant – which of course is highly unlikely to be the case

    1. Counter-balancing use of fiscal and monetary policy: For example the government can alter
       fiscal policy to manage the level of AD and the Bank of England has the flexibility to change interest
       rates (e.g. lower interest rates if they felt that a high exchange rate was damaging export sectors and
       causing much lower inflation)
    2. Low elasticity of demand: In the short term, the effects of exchange rates on export and import
       demand tends to be low because of low price elasticity of demand
    3. Business response to the challenge of a high exchange rate: Businesses can and do adapt to a
       high exchange rate. There are several ways in which industries can adjust to the competitive
       pressures that a strong pound imposes. Some of the options include:

            a) Cutting their export prices when selling in overseas markets and therefore accepting lower
               profit margins to maintain competitiveness and market share

            b) Out-sourcing components from overseas to keep production costs down

            c) Seeking productivity / efficiency gains to keep unit labour costs under control or perhaps
               trying to negotiate a reduction in pay levels

                                                                                                     - 88 -

           d) Investing extra resources in new product lines where demand is price inelastic and less
              sensitive to exchange rate fluctuations. This involves producing products with a higher
              income elasticity of demand, where non-price factors such as product quality, design and
              effective marketing are as important in securing orders as the actual price

London is the major centre for foreign exchange trading in the world economy – the market is nearly wholly
               screen based and billions of dollars worth of currencies is traded every hour

                                                                                                                         - 89 -

    20. Fiscal Policy

Fiscal policy involves the use of government spending, taxation and borrowing to influence both the
pattern of economic activity and also the level and growth of aggregate demand, output and employment. It
is important to realise that changes in fiscal policy affect both aggregate demand (AD) and aggregate
supply (AS).

Fiscal Policy and Aggregate Demand

Traditionally fiscal policy has been seen as an instrument of demand management. This means that
changes in government spending, direct and indirect taxation and the budget balance can be used to help
smooth out some of the volatility of real national output particularly when the economy has experienced an
external shock. For example, from 2001-2005 there has been a fiscal stimulus to the UK economy
through substantial increases in government spending on transport, and in particular heavier spending in the
twin areas of health and education. This fiscal stimulus will come to an end in the next couple of years as the
government slows down the rate of which its own spending is increasing.

    •   The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand,
        output and employment when the economy is operating well below full capacity national output, and
        where there is a need to provide a demand-stimulus to the economy. Keynesians believe that there
        is a clear and justified role for the government to make active use of fiscal policy measures to
        manage the level of aggregate demand.

    •   Monetarist economists on the other hand believe that government spending and tax changes can
        only have a temporary effect on aggregate demand, output and jobs and that monetary policy is a
        more effective instrument for controlling demand and inflationary pressure. They are much more
        sceptical about the wisdom of relying on fiscal policy as a means of demand management.

The fiscal policy transmission mechanism

                          Cut in personal income tax         Boost to disposable income       Adds to consumer demand

                          Cut in indirect taxes              Lower prices – leads to          Adds to consumer demand
                                                             higher real incomes
    Expansionary Fiscal

                           Cut in corporation tax             Higher “post tax” profits       Adds to business capital
                                                              for businesses                  spending

                           Cut in tax on interest from        Boost to disposable income of   Adds to consumer demand
                           saving                             people with net savings

How does a change in fiscal policy feed through the economy to affect variables such as aggregate demand,
national output, prices and employment? This simple flow-chart above identifies some of the possible
channels involved with the fiscal policy transmission mechanism.

The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity
the economy has; how much of any increase in disposable income is spent rather than saved or spent on
imports. And also the effects of fiscal policy on variables such as interest rates

                                                                                                          - 90 -

Government spending

Government (or public) spending each year takes up over 40% of gross domestic product. Spending by the
public sector can be broken down into three main areas:

    1. Transfer Payments: Transfer payments are government welfare payments made available
       through the social security system including the Jobseekers’ Allowance, Child Benefit, the basic
       State Pension, Housing Benefit, Income Support and the Working Families Tax Credit. These
       transfer payments are not included in the national income accounts because they are not a payment
       for output produced directly by a factor of production. Neither are they included in general
       government spending on goods and services. The main aim of transfer payments is to provide a
       basic floor of income or minimum standard of living for low income households in our society. And
       they also provide a means by which the government can change the overall distribution of income in
       a country.
    2. Current Government Spending: i.e. spending on state-provided goods & services that are
       provided on a recurrent basis every week, month and year, for example salaries paid to people
       working in the NHS and resources used in providing state education and defence. Current spending
       is recurring because these services have to be provided day to day throughout the country. The NHS
       claims a sizeable proportion of total current spending – hardly surprising as it is the country’s biggest
       employer with over one million people working within the system!
    3. Capital Spending: Capital spending would include infrastructural spending such as spending on
       new motorways and roads, hospitals, schools and prisons. This investment spending by the
       government adds to the economy’s capital stock and clearly can have important demand and supply
       side effects in the medium to long term.

Government spending is justified on economic and social grounds including the desire to correct for
perceived market failure when the market mechanism might fail to provide sufficient public and merit goods
for social welfare to be maximized.

Therefore we justify government spending on these grounds:
    1. To provide a socially efficient level of public goods and merit goods
    2. To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in
       society – this is also part of the process of redistributing income and wealth
    3. To provide necessary infrastructure via capital spending on transport, education and health
       facilities – an important component of a country’s long run aggregate supply
    4. As a means of managing the level and growth of AD to meet the government’s main
       macroeconomic policy objectives such as low inflation and high levels of employment

The Private Finance Initiative (PFI)

                                                                                                               - 91 -

The Private Finance Initiative is a way of funding expensive infrastructure developments without running up
debts. Rather than borrowing to fund new projects, John Major's government entered into a long-term
leasing agreement with private contractors. Under a PFI, companies borrow the cash to build and run new
hospitals, schools and prisons for a period of up to 60 years. So far, about 150 PFI contracts have been
signed, worth more than £40bn, with more in the pipeline. PFI is often portrayed as using private money to
pay for improvements in public services. But, critics argue, it is still paid for through the public purse. It is not
new money. Furthermore, the critics say, private finance is, by its nature, more expensive than public capital.
The government of the day may feel it is getting a hospital or school at a bargain price but the country will
pay more in the long run.

Automatic stabilisers and discretionary changes in fiscal policy

Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending –
for example a decision by the government to increase total capital spending on the road building budget or
increase the allocation of resources going direct into the NHS.

Automatic stabilisers include those changes in tax revenues and government spending that come about
automatically as the economy moves through different stages of the business cycle
    1. Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which
       takes money out of the circular flow of income and spending
    2. Welfare spending: A growing economy means that the government does not have to spend as
       much on means-tested welfare benefits such as income support and unemployment benefits
    3. Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of
       money from the circular flow. Conversely during a slowdown or a recession, the government
       normally ends up running a larger budget deficit.


We now turn to the revenue that flows into the government’s accounts from taxation. There are so many
different kinds of taxation and the tax system itself often appears to be horrendously complex! But one
important distinction to make is between direct and indirect taxes.

    •   Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, national
        insurance contributions, capital gains tax, and corporation tax.

    •   Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and
        Value Added Tax (VAT) on many different goods and services

By far the biggest source of income for the government is income tax. In the last tax year the state received
over £127 billion in income tax receipts, nearly fifty billion pounds higher than the income from national
insurance contributions. For more on taxation in the UK, click here.

Income from selected range of taxes for the UK government                             1999-00           2004-05
                                                                                      £ billion         £ billion
Income tax                                                                              95.7             127.2
National Insurance contributions                                                        56.1              78.1
VAT                                                                                     56.4              73.0
Corporation tax                                                                         34.3              34.1
Fuel duties                                                                             22.5              23.3
Council Tax                                                                             13.1              20.1
Business rates                                                                          15.4              18.7
Other taxes                                                                              8.1              11.7
Stamp duties                                                                             6.9               9.0
Tobacco duty                                                                             5.7               8.1
Vehicle excise duty                                                                     4.9               4.7
Beer & cider duties                                                                     3.0               3.3

                                                                                                                                           - 92 -

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

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





       GBP (billions)



                        60     Income tax



                               Corporation Tax

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

                                     Income Tax             VAT               Corporation Tax
                                                                                                                  Source: Reuters EcoWin

Progressive, proportional and regressive taxes

   •       With a progressive tax, the marginal rate of tax rises as income rises. I.e. as people earn more
           income, the rate of tax on each extra pound earned goes up. This causes a rise in the average rate
           of tax (the percentage of income paid in tax). The UK income tax system is progressive. Everyone is
           entitled to a tax-free income. Thereafter, as income grows, people pay the starting rate of tax (10%)
           before moving onto the basic tax rate (22%). Higher income earners pay the top rate of tax (40%) on
           each additional pound of income over the top rate tax limit. This is the highest rate of income tax

   •       With a proportional tax, the marginal rate of tax is constant. For example, we might have an income
           tax system that applied a standard rate of tax of 25% across all income levels. If the marginal rate of
           tax is constant, the average rate of tax will also be constant. National insurance contributions are the
           closest example in the UK of a proportional tax, although low-income earners do not pay NICs below
           an income threshold, and NICs also do not rise for income earned above a top threshold.

   •       With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate of tax is lower for
           people of higher incomes. In the UK, most examples of regressive taxes come from excise duties of
           items of spending such as cigarettes and alcohol. There is well-documented evidence that the heavy
           excise duty applied on tobacco has quite a regressive impact on the distribution of income in the UK.

Fiscal Policy and Aggregate Supply

                                                                                                            - 93 -

Changes to fiscal policy can affect the supply-side capacity of the economy and therefore contribute to long
term economic growth. The effects tend to be longer term in nature.
    1. Labour market incentives: Cuts in income tax might be used to improve incentives for people to
       actively seek work and also as a strategy to boost labour productivity. Some economists argue that
       welfare benefit reforms are more important than tax cuts in improving incentives – in particular to
       create a “wedge” or gap between the incomes of those people in work and those who are in
       voluntary unemployment.
    2. Capital spending. Government capital spending on the national infrastructure (e.g. improvements to
       our motorway network or an increase in the building programme for new schools and hospitals)
       contributes to an increase in investment across the whole economy. Lower rates of corporation tax
       and other business taxes might also be used as a policy to stimulate a higher level of business
       investment and attract inward investment from overseas
    3. Entrepreneurship and new business creation: Government spending might be used to fund an
       expansion in the rate of new small business start-ups
    4. Research and development and innovation: Government spending, tax credits and other tax
       allowances could be used to encourage an increase in private business sector research and
       development – designed to improve the international competitiveness of domestic businesses and
       contribute to a faster pace of innovation and invention
    5. Human capital of the workforce: Higher government spending on education and training (designed
       to boost the human capital of the workforce) and increased investment in health and transport can
       also have important supply-side economic effects in the long run. An enhanced transport
       infrastructure is seen by many business organisations as absolutely essential if the UK is to remain
       competitive within the European and global economy

Free market economists are normally sceptical of the effects of government spending in improving the
supply-side of the economy. They argue that lower taxation and tight control of government spending and
borrowing is required to allow the private sector of the economy to flourish. They believe in a smaller sized
state sector so that in the long run, the overall burden of taxation can come down and thus allow the private
sector of the economy to grow and flourish.

However targeted government spending and tax decisions can have a positive impact even though fiscal
policy reforms take a long time to feed through. The key is to help provide the right incentives for individuals
and businesses – for example the incentives to find work and incentives for businesses to increase
employment and investment.

                                                                                                                 - 94 -

    21. Government borrowing – the budget deficit

In this chapter we consider the effects that government borrowing to finance their spending can have on the
wider performance of the economy.

The level of government borrowing is an important part of fiscal policy and management of aggregate
demand in any economy. When the government is running a budget deficit, it means that in a given year,
total government expenditure exceeds total tax revenue.

If the government is running a budget deficit, it has to borrow this money through the issue of government
debt such as Treasury Bills and long-term government bonds. The issue of debt is done by the central bank
and involves selling debt to the bond and bill markets. Most of the government debt is bought up by financial
institutions but individuals can buy bonds, premium bonds and buy national savings certificates.

Government finances have moved from surplus in the late 1990s to a deficit of over 2% of GDP in 2006.
The emergence of a rising budget deficit has been due to a weaker economy and the effects of increases in
government spending on priority areas such as health, education, transport and defence. Critics of Gordon
Brown argue that he risks losing control of the budget deficit if tax revenues continue to come in below
forecast whilst public sector spending remains high. Gordon Brown’s reputation of fiscal prudence has come
under pressure over the last few years. He is forecast to be running a budget deficit of over 3% of GDP (in
excess of £32 billion) in 2006.

                              United Kingdom Government Budget (Fiscal) Balance
                                                             £ billion



        £ (billions)





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

                                                                                        Source: Reuters EcoWin
Does a budget deficit matter?

There is a consensus that a persistently large budget deficit can turn out to be a major problem for the
government and the economy. Three of the reasons for this are as follows:
    1. Financing a deficit: A budget deficit has to be financed and day-today, the issue of new
       government debt to domestic or overseas investors can do this. But it may be that if the budget
       deficit rises to a high level, the government may have to offer higher interest rates to attract buyers
       of government debt. In the long run, higher government borrowing today may mean that taxes will
       have to rise in the future and this would put a squeeze on spending by private sector businesses and
       millions of households.
    2. A government debt mountain? In the long run, a high level of government borrowing adds to the
       accumulated National Debt. This means that the Government has to spend more each year in debt-
       interest payments to holders of government bonds and other securities. There is an opportunity

                                                                                                        - 95 -

        cost involved here because interest payments might be used in more productive ways, for example
        an increase in spending on health services. It also represents a transfer of income from people and
        businesses that pay taxes to those who hold government debt and cause a redistribution of income
        and wealth in the economy
   3. Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of
      government spending. They believe that a rising share of GDP taken by the state sector has a
      negative effect on the growth of the private sector of the economy. They are sceptical about the
      benefits of higher spending believing that the scale of waste in the public sector is high – money that
      would be better off being used by the private sector.

Potential benefits of a budget deficit

What are the main economic and social justifications for a higher level of government spending and
borrowing? Two main arguments stand out

    1. Government borrowing can benefit economic growth: A budget deficit can have positive
       macroeconomic effects in the long run if it is used to finance extra capital spending that leads to an
       increase in the stock of national assets. For example, higher spending on the transport
       infrastructure improves the supply-side capacity of the economy promoting long-run growth. And
       increased public-sector investment in health and education can bring positive effects on labour
       productivity and employment. The social benefits of increased capital spending can be estimated
       through use of cost-benefit analysis.

    2. The budget deficit as a tool of demand management: Keynesian economists would support the
       use of changing the level of borrowing as a way of fine-tuning or managing the level of aggregate
       demand. An increase in borrowing can be a stimulus to demand when other sectors of the
       economy are suffering from weak spending. The fiscal stimulus given to the British economy during
       2002-2005 has been important in stabilizing demand and output at a time of global uncertainty.
       The argument is that the government can and should use fiscal policy to keep real national output
       closer to potential GDP so that we avoid a large negative output gap. Maintaining a high level of
       demand helps to sustain growth and keep unemployment low.

                                                                                                             - 96 -

    22. Supply-side Policies

In this chapter we take a walk on the supply-side of the economy. The “supply side” refers to factors affecting
the quantity or quality of goods and services produced by an economy such as the level of productivity or
investment in research and development.

What are supply-side policies?

Supply-side economic policies are mainly micro-economic policies designed to improve the supply-side
potential of an economy, make markets and industries operate more efficiently and thereby contribute to a
faster rate of growth of real national output

Most governments now accept that an improved supply-side performance is the key to achieving sustained
economic growth without a rise in inflation. But supply-side reform on its own is not enough to achieve
this growth. There must also be a high enough level of aggregate demand so that the productive capacity
of an economy is actually brought into play.

There are two broad approaches to the supply-side. Firstly policies focused on product markets where
goods and services are produced and sold to consumers and secondly the labour market – a factor market
where labour is bought and sold.

Supply Side Policies for Product Markets

Product markets refer to markets in which all kinds of commodities are traded, for example the market for
airline travel; for mobile phones, for new cars; for pharmaceutical products and the markets for financial
services such as banking and occupational pensions.

Supply-side policies in product markets are designed to increase competition and efficiency. If the
productivity of an industry improves, then it will be able to produce more with a given amount of resources,
shifting the LRAS curve to the right.


Over the last twenty-five years, many former state-owned businesses have been privatised – i.e. they have
transferred from the public sector into the private sector. Examples in Britain include British Gas, British
Telecom, British Airways, British Steel, British Aerospace, the regional water companies, the main electricity
generators and distributors, and the Railways.

British Rail was privatised in 1994 but the failure of Railtrack led to the creation of Network Rail, a ‘not for
profit’ company in 2002. The Labour Government has continued to privatise or part-privatise other parts of
the UK public sector since it came to power in 1997.

Privatization is designed to break up state monopolies and create more competition. The government also
created utility regulators who have imposed price controls on many of these industries and who are now
over-seeing the move towards competitive markets in areas such as gas and electricity supply and

Deregulation of Markets

De-regulation or liberalisation means the opening up of markets to greater competition. The aim of this
is to increase market supply (driving prices down) and widen the range of choice available to
consumers. The discipline of competition should also lead to greater cost efficiency from producers – who
are keen to hold onto their existing market share. Good examples of deregulation to use include: urban bus
transport, parcel delivery services, mortgage lending, telecommunications, and gas and electricity supply.

Toughening up of Competition Policy

Most supply-side economists believe in the dynamic effects of greater competition and that competition
forces business to become more efficient in the way in which they use scarce resources. This reduces costs
which can be passed down to consumers in the form of lower prices. A tougher competition policy regime

                                                                                                           - 97 -

includes policies designed to curb anti-competitive practices such as price-fixing cartels and other abuses
of a dominant market position – in other words – intervention to curb some of the market failure that can
come from monopoly power

A commitment to free international trade

Trade between nations creates competition and should be a catalyst for improvements in costs and lower
prices for consumers. The UK government is committed to an expansion of free trade within the European
Single Market and also to negotiating a liberalisation of trade in the global economy as part of its
membership of the World Trade Organisation. For example, it wants to see further reforms of the Common
Agricultural Policy as a stepping-stone to global trade agreements between Europe, the United States and
developing countries.

Measures to encourage small business start-ups / entrepreneurship

The small businesses of today can often become the larger businesses of tomorrow, adding to national
output, employing more workers and contributing to innovative behaviour that can have positive spill-over
effects in other industries. Governments of all political persuasion argue that they want to promote an
entrepreneurial culture and to increase the rate of new business start-ups. Supply side policies include
loan guarantees for new businesses; regional policy assistance for entrepreneurs in depressed areas of the
country; advice for new firms

Capital investment and innovation:

Capital spending by firms adds to aggregate demand (C+I+G+(X-M)) but also has an important effect on
long run aggregate supply. Supply side policies would include tax relief on research and development and
reductions in the rate of corporation tax. Ireland is a good example of a country inside the EU that has
benefited hugely from cutting company taxes which has led to a large rise in foreign direct investment. One
of the new countries joining the EU in 2004, Estonia, has cut its corporation tax rate to zero per cent (0%) in
a deliberate attempt to attract new investment and stimulate economic growth and employment. There are
now big differences in corporation tax rates among the twenty five nations of the European Union.

                           Corporate Tax Rates in the European Union in 2004

Estonia                                   0.0%        Luxembourg                                         30.0%
Ireland                                  12.5%        Denmark                                            30.0%
Lithuania                                15.0%        Czech Rep.                                         31.0%
Cyprus                                   15.0%        Portugal                                           33.0%
Latvia                                   19.0%        Austria                                            34.0%
Slovakia                                 19.0%        Belgium                                            34.0%
Poland                                   19.0%        Italy                                              34.0%
Hungary                                  20.0%        Netherlands                                        34.5%
Slovenia                                 25.0%        Spain                                              35.0%
Sweden                                   28.0%        Greece                                             35.0%
Finland                                  29.0%        France                                             35.4%
UK                                       30.0%        Germany                                            38.7%

The issue of incentives is crucial for if inventions and innovations can be widely and easily copied and
implemented, then the rewards to those engaged in cutting-edge research might be diluted leading to a
decrease in the willingness of entrepreneurs to take risks.

Innovation and Economic Growth

‘A dynamic environment with opportunities for enterprise and innovation is vital to improving economic
performance. New businesses entering the marketplace increase competitive pressures facilitating the
introduction of new ideas and technologies. The Government is therefore committed to supporting enterprise
and innovation throughout the economy, including in Britain’s most disadvantaged areas.’
                                               Source: Government Spending Review Statement, July 2002

Supply side policies for the Labour Market

                                                                                                               - 98 -

These policies are designed to improve the quality and quantity of the supply of labour available to the
economy. They seek to make the British labour market more flexible so that it is better able to match the
labour force to the demands placed upon it by employers in expanding sectors thereby reducing the risk of
structural unemployment. An expansion in the UK’s total labour supply increases the productive potential of
an economy. That expansion in the supply of people willing and able to work can come from several
sources for example: encouraging older people to stay in the workforce; a relaxed approach to labour
migration and measures to get non-working parents to actively look for work.

Trade Union Reforms

Many of the traditional legal protections enjoyed by the trade unions have been taken away – including
restrictions on their ability to take industrial action and enter into restrictive practices agreements with
employers. The result has been a decrease in strike action in virtually every industry and a significant
improvement in industrial relations in the UK.

Increased Spending on Education and Training

Economists disagree about the scale of the likely economic and social returns to be earned from higher
spending on education – but few of them deny that “investment in education” has the potential to raise the
skills within the work force and improve the employment prospects of thousands of unemployed workers.
The economic returns from extra education spending can vary according to the stage of development that a
country has achieved.

Government spending on education and training improves workers’ human capital. Economies that have
invested heavily in education are those that are well set for the future. Most economists agree, with the move
away from industries that required manual skills to those that need mental skills, that investment in
education, and the retraining of previously manual workers, is absolutely vital.

It should also be noted that improved training, especially for those who lose their job in an old industry
should improve the occupational mobility of workers in the economy. This should help reduce the problem of
structural unemployment. A well-educated workforce acts as a magnet for foreign investment in the

Income Tax Reforms and the Incentive to Work

Economists who support supply-side policies believe that lower rates of income tax provide a short-term
boost to demand, and they improve incentives for people to work longer hours or take a new job – because
they get to keep a higher percentage of the money they earn.

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

Do lower taxes really help to increase the active labour supply in the economy? It seems obvious that lower
taxes should boost the incentive to work because tax cuts increase the reward from a job. But some people
may choose to work the same number of hours and simply take a rise in their post-tax income! Millions of
other workers have little choice over the hours that they work.

Showing the effects of supply-side improvements in the economy

Supply-side factors often help to explain why it is that some countries grow faster than others. In a world of
globalisation, it is becoming clearer that maintaining and improving competitiveness is vital in achieving
success in international markets. A rising share of GDP in most countries is devoted to international trade.
Markets are becoming more competitive and those countries whose supply-side lets those down can find a
rising level of import penetration into their domestic markets and a weak export performance in goods and

                                                                                                                    - 99 -

                                                      LRAS1                LRAS2
   Inflation                                                                         An outward shift in LRAS helps to
                                                                                    increase the economy’s underlying
                                                                                    trend rate of growth – it represents
                                                                                       an increase in potential GDP



                                                Y1              Y1          YFC2                    National Income

Supply side improvements can also be shown using a production possibility frontier

Supply side policies and productivity

It is important to recognise that the supply-side does not operate in isolation from changes in
aggregate demand. If there is insufficient AD, it is unlikely that better supply-side performance can be
achieved over a number of years. Equally, if aggregate demand grows too quickly, acceleration in wage and
price inflation might require deflationary policies that ultimately harm a country’s productive potential.

                                                                                                        - 100 -

Evaluating the UK’s supply-side performance

On the right tracks

“There has been a remarkable structural improvement in the British economy. This began under Margaret
Thatcher and has largely been maintained under Tony Blair. Deregulation, privatisation, reductions in trade
union power and reform of unemployment benefits have transformed the business environment.”
                                   Source: Ed Crooks, Economics editor of the Financial Times. June 2004

Improvements in the Supply Side                         Supply-Side Weaknesses
   • Sustained economic growth. The UK has                 • There remains a large productivity between
      maintained its position as the 4th largest               the UK and other leading economies – this is
      economy in the world and has weathered the               now a major focus of supply side policies
      global economic downturn well
   • There has been a large fall in unemployment           •     Sharp rise in the balance of payments deficit
      and a record level of employment. The UK                   in goods and services – suggesting
      currently has the highest employment ratio in              continued problems of international
      the EU                                                     competitiveness
   • Falling unemployment and continued low                •     Few signs that the underlying rate of
      inflation – suggesting an improvement in the               economic growth has improved above 2.5%
      trade-off between these two important                      per year – other countries have a faster rate
      macroeconomic objectives                                   of growth of potential output
                                                           •     Service sector has been strong but
                                                                 manufacturing industry has suffered three
                                                                 recessions in the last ten years
    •   The UK labour market is seen as one of the         •     Still an investment gap (including under-
        most flexible among leading economies, with              investment in public sector services such as
        a rising level of occupational flexibility of            education, health and transport) and the UK
        labour                                                   devotes a falling share of GDP to business
                                                                 research and development

There is a general consensus that the supply-side of the British economy has improved over the last twenty
years even though there are still weaknesses in several sectors and the UK must face up to increasingly
fierce competition from other countries as the effects of globalisation take hold. Our product and labour
markets are more flexible than they were a decade ago but many businesses complain that government
intervention places too heavy a cost of administration and other forms of red-tape and that this acts as a
barrier to future investment and growth. Increasing amounts of regulation both from the UK and the
European Union can add to business costs and reduce competitiveness.

                                                                                                            - 101 -

    23. Trade-Offs between Objectives

It is rare for any government to be able to meet all its objectives at the same time. The complexity of the
economy and the limitations of economic policies make this a really tough task! In this chapter we consider
possible trade-offs between the key policy objectives.

There are potential trade-offs between objectives imply that choices between different goals may have to be
made in the short and medium run.
                  Should the highest priority be given to keeping inflation firmly under control?
                  Or can the British economy now operate at a higher level of GDP growth and lower
                  unemployment without worrying too much about the inflationary consequences?
                  Should the government be concerned about a large and rising trade deficit with other
                  countries? Or can the trade deficit be ignored because it is the result of a high level of short
                  term growth and strong consumer spending?

Unemployment and Inflation – the Phillips Curve




            P1                                                                        Short Run Phillips Curve

                               U3              U2                          U1        Unemployment Rate (%)

Is there a trade-off between unemployment and inflation?

Arguments for a trade-off:

When unemployment falls to low levels, there is a risk that wage and price inflation will pick up. The demand
for labour is increasing and labour shortages in many industries and occupations may arise. This puts
upward pressure on pay as employers offer higher pay both to recruit and retain their key workers.

Falling unemployment leads to an increase in AD which can lead to demand pull inflation if SRAS is inelastic
and the output gap has become positive. As the economy heads towards full-employment, there is a danger
than inflation will accelerate and that economic policy will have to be tightened (for example a rise in taxation
or an increase in interest rates). The diagrams below illustrate an outward shift of the demand for labour
during an economic boom and an increase in AD from AD1 to AD2 when SRAS is inelastic.

                                                                                                                                                 - 102 -

 Real Wage                                                                    Inflation                                        LRAS

                                                                          Supply of




                                                                       LD1        LD2

                                                    E1      E2                YFC2                                            Y1 Y2 Yfc

                                                                  Employment of Labour                                    Real National Income

Unemployment has many causes and there is no automatic rule that falling unemployment must lead to
rising inflation. It is widely acknowledged that the relationship between unemployment and inflation in the UK
(and some other countries) has altered over the last fifteen years. As a consequence, the British economy
has enjoyed a very long period of falling unemployment without any significant acceleration in inflation. This
is shown in the data chart on the next page.

                                                             Unemployment and Inflation
                                                           unemployment and inflation rates - per cent




                   5                           Inflation





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

                             Consumer Price Inflation [ar 12 months]              Claimant Count Unemployment
                                                                                                                     Source: Reuters EcoWin

Why has the “trade-off” between unemployment and inflation changed?

Some economists point to the effect of supply side improvements in the British economy such as higher
capital investment; increases in productivity, lower labour costs and the benefits of rapid innovation. All of
these factors have helped to increase the supply-side potential of the economy which has contributed to a
period of non-inflationary growth.

                                                                                                       - 103 -

But it would be wrong to automatically assume that inflation is now dead! There are plenty of possible
causes of a return to higher inflation. For example, the UK is not immune to fluctuations in global commodity
prices, or the effects of a sharp fall in the exchange rate. And too much domestic demand for goods and
services, perhaps driven by the continued boom in house prices and consumer borrowing, might also bring
about a return of demand-pull inflationary pressure.

Is there a trade-off between economic growth and inflation?

Arguments for the trade-off

Sustained growth caused by rising aggregate demand can lead to acceleration in inflation as the economy
uses up scarce resources and short run aggregate supply becomes inelastic. When SRAS is elastic, an
outward shift of aggregate demand can easily be met by a rise in real GDP (there is plenty of spare capacity
and supply responds elastically to the higher level of AD). But when SRAS becomes inelastic, the trade-off
between growth and inflation worsens – an increase in AD tends to lead to higher prices rather than
increased output and employment.


The trade off between growth and inflation can be avoided if an economy is able to increase potential output
by improving their supply-side performance. For example, LRAS can be increased by achieving sustained
improvements in productivity, advances in technology and the benefits that come from product and process
innovations. Potential output is also increased by expanding the stock of capital goods (via higher
investment) and through an increase in the available labour supply.

An outward shift in LRAS means that the economy can meet a higher level of aggregate demand without
putting upward pressure on the general price level. This is shown in the diagram below. LRAS has moved to
the right (an increase in potential GDP). Aggregate demand has also shifted out (perhaps due to lower
interest rates or higher real incomes for consumers). Equilibrium national output increases from Y1 to Y2 –
the level of output Y2 would not have been feasible without a shift in LRAS.

       Inflation                                   LRAS1          LRAS2


                                                                  AD1              AD2

                                              Y1             Y2         YFC2

                                                                          Real National Income

                                                                                                                                               - 104 -

Clearly those countries that grow very quickly are at risk of rising inflation. The key is to keep control of
aggregate demand (using monetary and fiscal policy) whilst at the same time seeking to increase aggregate
supply through improvements in efficiency and the stock of available resources.

If we look at the data for economic growth and inflation in the UK over the last fifteen years, we see that
there has indeed been an improvement in the trade-off between these two objectives. In the late 1980s, an
economic boom got out of control and excess demand led to a sudden and sharp rise in cost and price
inflation. The rate of inflation peaked at over 10% in 1990 and interest rates were increased up to a
maximum of 15% in order to bring aggregate demand under control. The result of this was a deep recession
lasting for nearly two years – the effect of which was to reduce inflation but which also caused a huge rise in

Since the early 1990s the British economy has enjoyed a period of relative macroeconomic stability, with a
sustained phase of economic growth allied to continued low inflation. There have been some years of very
strong growth (for example in 1997 when real GDP increased by 3.4% and also in 2000 when the economy
expanded by 3%). But on the whole the economy has avoided excessive growth of demand which can cause

Part of the reason for this has been the management of aggregate demand using monetary policy by the
independent Bank of England. They have kept the output gap to very low levels (indicating an economy
close to macroeconomic equilibrium) whilst a combination of other favourable factors on the demand and
supply side of the economy has contributed to low inflation. In the absence of a major external inflationary
shock from the global economy, there is every reason to believe that the British economy can continue to
enjoy a combination of steady growth and low inflation. But this requires the supply-side of the economy to
continue to deliver higher levels of productivity and investment to give the economy the productive capacity
to meet demand and to maintain the competitiveness of UK producers in global markets.

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

                                           Consumer Price Inflation (CPI)








                                        Real GDP growth

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

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

Economic Growth and the Balance of Payments

Is there a trade off between fast economic growth and a worsening of the balance of trade in goods and

Arguments for the trade-off

                                                                                                         - 105 -

When aggregate demand is high and domestic producers are unable to meet all of this demand, so the
demand for imported goods and services will increase leading to an increase in the trade deficit. This trade-
off is evident when the main source of rising AD is a high level of consumer spending. British consumers
have a high propensity to import goods and services. As their incomes increase, so too does their demand
for imports. The trade-off is worsened by the lack of international competitiveness of many UK industries
compared to other leading countries.

The experience of the UK in recent years shows that the size of the trade deficit is largely cyclical. The
strong growth of GDP and consumer demand has led to a large increase in the trade deficit in goods and
services. This suggests that if the government wants to reduce the trade deficit, then it must accept that
consumer demand (and GDP) must eventually grow at a slower rate in order to reduce the imbalance
between exports and imports.


Economic growth can be achieved without a worsening of the balance of payments in goods and services.
The causes of a trade deficit are not solely cyclical – there are structural explanations too – indeed in the
long run, the main causes of imports out-pacing exports relate to the competitiveness of UK producers in
their own domestic markets and when trying to export overseas.

Much depends on the strength of the exchange rate. When sterling is strong, the relative prices of imports
coming into the UK falls, and British exports because more expensive in international markets – these
causes a slowdown in export sales and a rise in the demand for imports. Depreciation in the exchange rate
would provide a competitive boost to UK producers and might lead to an improvement in our balance of
payments. However, a low exchange rate would also lead to an increase in the costs of imported goods and
services risking higher “cost-push” inflation.

Exports can also be increased if our domestic industries increase their competitiveness in other ways: higher
productivity helps to reduce unit costs; greater investment in new capital and research and development can
lead to a faster pace of innovation and the development of new products in export sectors. Non-price
competitiveness can also be improved by better design, after sales service, guaranteed delivery dates and
more effective marketing.

Export-led growth (i.e. increases in aggregate demand brought about by an increase in the value of exported
goods and services) can bring about economic growth without deterioration in a country’s trade balance.

A worsening of the trade balance in goods and services acts as a drag on short term economic growth for a
country because imports are counted as a withdrawal from the circular flow of income and spending – so a
surge in demand for overseas-produced goods and services leads to a flow of income and demand out of
the economy.

                                                                                                            - 106 -

    24. Exam Technique for your macroeconomics paper

The AS macroeconomics exam on the National and International economy tests four types of assessment
objectives, knowledge, application of knowledge, analysis and evaluation:

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

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

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

    o      Level 4 tests your ability to evaluate problems and policies and make informed judgements based
           on theory and evidence e.g. short term and long term implications

           Evaluation must be based on appropriate analysis for L4 marks to be awarded

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

Knowledge & Application of Knowledge                      Analyse Economic Problems and Issues

Calculate               Work out making use of            Analyse                Set out the main points
                        the information provided
Define                  Give the exact meaning            Apply                  Use in a specific way
Describe                Give a description of             Compare                Give similarities and differences
Give (an account)       As `describe'                     Consider               Give your thoughts about
Give (an example)       Give a particular example         Explain (why)          Give clear reasons
How (explain how)       In what way(s)                    Justify/account for    Give reasons for
Identify                Point out
Illustrate              Give examples/diagram             Evaluate Economic Arguments and Evidence -
                                                          making Informed Judgements

Outline                 Describe without detail           Assess                Show how important something is
State                   Make clear                        Criticise             Give an opinion, but support it
                                                                                with evidence
Summarize               Give main points, without         Discuss               Give the importance arguments,
                        detail                                                  for and against
Which                   Give a clear example /            Evaluate              Discuss the importance of,
                        state what                                              making some attempt to weight
                                                                                your opinions
                                                          To what extent        Make a judgement


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