Economics - module 2 - unit 3

Unit 3 - Economic Performance

The Macroeconomic Objectives of the UK Government1. To increase the growth performance of the economy by raising the trend rate of growth. The trend rate is the increase in the productive capacity that is sustainable without causing inflation above a rate of 2%. The Trend rate of growth for the UK was considered to be about 2.5% prior to 2007 but is now probably closer to 2.25%. 2. To minimise unemployment and therefore increase the proportion of the working population who are in work. The working population is the number of individuals between 16 and 65 who are able to work. There are two measures but the Government uses the International labour force survey which recorded unemployment at 2.5m Dec 2012. 3. To achieve price stability meaning, maintaining the average rise in prices at 2% per year. This is the rate that is considered compatible with achieving a trend rate of growth of 2.25%. The UK Government uses the Consumer price index (CPI) as its measure of inflation. Inflation is defined as the average rise in prices. 4. To achieve an external trade balance meaning exports equal imports. The UK suffers from a current account deficit meaning the import of goods and services exceeds the exports of goods and services. Improving productivity is regarded as key to reducing the UK’s deficit of imports over exports. Productivity can be improved through raising levels of Education & Training, investment in capital goods, a higher labour supply (e.g. through immigration) and management.

The Multiplier Effect An initial change in aggregate demand will lead to a greater change in real national income and output. A positive multiplier effect means an initial rise in consumer spending will lead to a greate rise in real GDP. A negative multiplier effect means an initial fall in consumer spending will lead to a greater fall in real GDP. The reason for this is because: Firms will increase investment spending to expand their productive capacity to meet higher demand. The government will also increase spending as they will generate higher tax revenues. The effect of injections on the multiplier effect:A greater level of injections into the economy will increase spending and cause a greater multiplier effect.The effect of leakages on the multiplier effect:A greater level of leakages in the economy will lead to a smaller multiplier effect of an increase in injections.The accelerator principleThis is the principle stating that an initial change in GDP will cause a change in the rate of new investment. A rise in real GDP growth will cause a rise in the level of investment. A fall in real GDP growth will cause a fall in the level of investment.

Demand side shocksA demand side shock is any factor that causes a significant change in aggregate demand such as the negative effect of the bank crisis on consumer confidence.

Supply side shocks A supply side shock is any factor that causes a change in short run aggregate supply such as a significant rise in oil prices

Economic shocksAn economic shock is a factor that causes the macroeconomic equilibrium to change and the economy to diverge from its potential or trend rate of growth. The effect of an economic shock on the macro economy is likely to be more significant because of the interaction of the multiplier and accelerator concepts.

The Output GapIn long run macroeconomic equilibrium is where the economy is operating at its trend rate of growth, or the potentail output. An output gap exists when actual output diverges from potential output. Potential output is indicated by the long run aggregate supply curve (LRAS).

If the economy is operating above its LRAS it is experiencing a positive output gap and is at risk of inflation This shows a positive output gap because the actual output of the economy is above the potential output of the economy. This means the economy is experiencing a boom because growth is above trend and there is a risk of inflation being above target.

If the economy is operating below its LRAS it is experiencing a negative output gap and this implies the economy is growing below its trend rate of growth and is at risk of unemployment. This shows a negative output gap because the actual output of the economy is below the potential output of the economy. This means economic growth is below trend and the economy is at risk of recession and rising unemployment

Inflation and DeflationInflation Inflation is defined as the average rise in the price level that causes a fall in the purchasing power of money leading to a fall in living standards In the UK, inflation is measured using the consumer price index (CPI) which is published monthly by the Bank of England. A basket of goods is chosen to represent the typical spend of an average household. Each month the price of each good is compared to the previous month and an average price change is calculated. Each item in the basket is weighted to reflect the amount a typical household will spend on this item. Hence, food prices have a higher weighting than alcohol to reflect that a household will spend a higher proportion of their budget on the former item. The inflation figure is announced every month and indicates the average rise in prices over the previous year. The 2 methods to calculate the rate inflation: Consumer Price Index (CPI) is used by the Bank of England for setting the base rate of inflation of 2%. CPI is used by the UK Treasury to set the increases in state benefits and pensions, having switched from RPI in 2010. CPI does not include mortgage costs. Retail Index Index (RPI) differs from CPI as it includes mortgage costs in its claculation, which the CPI excludes. The causes of Inflation

Demand Pull Inflation This occurs when the level of aggregate demand is growing faster than the productive capacity of the economy (AS) can cope with. This implies there is excess demand for goods and services which allows firms to raise prices in order to make higher profit. This type of inflation occurs during an economic boom when the economy is growing above its trend rate of economic growth. The trend rate of growth is the increase in productive capacity that can be sustained long term without generating demand pull inflation. The UK’s trend rate has been calculated at between 2.25% to 2.5%.

Cost Push Inflation This occurs when firms raise prices in response to a rise in their production costs. Production costs might be rising due to an increase in wage costs, material costs, Taxes such as excise and VAT, and energy costs. The effect of the cost push inflation is to shift the SRAS curve to the left. Therefore, the economy will be operating below its potential and there will be a negative output gap.

Why is inflation a threat to economic stability? Inflation reduces the purchasing power of money and so reduces the living standards of consumers. Rising prices creates uncertainty because consumers and producers are unsure about the price of goods and services. Inflation means goods and services are now more expensive and this reduces the competitiveness of UK exports. Inflation can cause the economy to grow at a slower rate than the potential trend rate and hence living standards fall because the purchasing power of consumers is reduced. The Government considers a CPI rate above 2% as excessive.

Deflation Deflation is defined as a fall in the average level of prices and means inflation is negative. Deflation is likely to occur during a recession when the productive capacity of the economy is shrinking in size. It indicates that households have lost confidence and are reducing consumption because they expect prices to be cheaper in the future and hence they delay the purchase of consumer durables. Therefore, just as inflation is a threat to economic stability, so too is deflation. Deflation would be a sign that the level of aggregate demand is decreasing causing spare capacity in the economy. This can have a negative multiplier effect and according to the accelerator principle will result in a fall in investment. The interaction of the multiplier and accelerator can cause a recession to become a depression

Employment and UnemploymentA key objective of the government is to minimise unemployment and encourage employment. This will benefit the economy because Employment leads to higher disposable income for individuals, and so higher spending. This also leads to higher tax revenues for the government leading to higher government spending. Employment can raise productivity leading to higher output at lower costs. Higher consumption has a positive multiplier effect. UnemploymentUnemployment is defined as those individuals who are out of work and actively seeking employment. Unemployment is also measured as a percentage of the labour force and this is defined as those in work and those registered as looking for work. This is also known as the economically active population, or working population. The working population is defined as those individuals aged between 16 and 65 who could potentially work and includes students and parents raising children.There are two basic measures of unemployment: The claimant count (CC) is based on those individuals who are claiming job seekers allowance. This measure excludes those unemployed individuals who are not eligible for JSA because either they have a high level of savings or live with a partner who is in work. The labour force survey (LFS) measure of unemployment is based on those individual who are actively seeking work and could start within two weeks. The LFS will always exceed the CC measure. The participation rate is the proportion of the working population who are in the labour force. However, not every one of working age is in employment or unemployment. Some may be: Students in full time education Disabled and therefore unable to work In prison Caring for dependents such as children, elderlyor handicapped The 4 types of unemployment1. Seasonal unemployment represents unemployment that is affected by seasonal factors. Unemployment may fall in the run up to Christmas as firms take on workers to meet Xmas orders and lay these workers off in the New Year when demand falls. The South West has a high level of seasonal unemployment because it main industry is tourism.Employers that may recruit staff on a seasonal basis include: Retail - supermarkets, clothing etc. - may recruit seasonal employees during busy periods such as christmas. Agriculture - Farming. Tourism. 2. Frictional unemployment usually lasts for less than one year and represents individuals who are moving between jobs or entering the labour market for the first time such as graduates. These people are out of work for only a short period of time. The duration and numbers unemployed for this reason will increase during recession but fall during a boom, because: Fewer jobs may be available during a recession and so there is higher competition. School and college leavers are at a disadvantage because they lack the qualifications. School, college and university leavers may find it difficult to get their first job because: They don't have the experience in work. They may have high expectations. There may be high competition for jobs. 3. Structural unemployment represents those individuals who remain unemployed from longer than one year These individuals remain unemployed for the long term because: They lack the necessary skills for the supply of jobs available and so are classed as being occupationally immobile. They can’t move location to where jobs are available because of high house prices and rents and so are classed as being geographically immobile. Structural unemployment is also considered a supply side type of unemployment because it represents a mismatch between the demand for and supply of labour in the economy. Structural or long term unemployment has become worse because of structural changes in the types of jobs being offered in the UK economy.4. Cyclical unemployment is caused when the level of aggregate demand falls below the level of aggregate supply necessary to maintain the economy at its trend rate of economic growth. This unemployment is therefore determined by demand side factors, but can lag behind changes in GDP by up to 12 months. Therefore, an initial change in the economic cycle will take longer to cause an initial change in the level of unemployment.

The Balance of Payments of the Current AccountThis is a country's financial record of its trade flows with rest of the world.Exports These are goods and services produced with in the UK but consumed outside the UK. They represent an injection of money into the UK economy and therefore increase the level of aggregate demand. Imports These are goods and services produced outside of the UK but consumed in the UK. They represent a withdrawal of money from the UK economy and so reduce the level of aggregate demand. Trade deficit vs. Trade surplus A trade surplus means the value of exports exceeds the value of imports. A trade deficit means the value of imports exceeds the value of exports. 1. The trade balance in goodsThe balance of trade in goods represents the difference between the exports and imports of physical goods. Physical goods are also known as visibles. Visible UK exports include - food, tobacco, alcohol, cars, defence, oil, minerals, aircraft, engines, technology, medicine, clothing, furniture and animals. The UK imports all types of items that it exports, and therefore Visible UK exports are the same. The trade balance of goods in the UK is currently in deficit, meaning imports exceed exports. The major eason for the worsening trade deficit in goods is due to: The decline of manufacturing in the UK. Rising consumer incomes. China emerging as a major expoter of manufactured goods. 2. The trade balance in servicesThe balance of trade in services represents the difference between the exports and imports of services. Services are also known as invisibles. UK service exports - Banking, finance, tourism, communications, TV (BBC), music royalties, private health care, foreign students, transportation. UK service imports - transportation, US sitcoms, tourism, UK students studying abroad, private health care. The trade balance of services in the UK is currently in surplus, meaning the exports of servives exceed imports. The main UK service export is financial services. The main UK service import is travel, as UK consumers enjoy going abroad. 3. Net investment IncomeThis represents the difference between the income the UK receives from investments made abroad and the income the UK pays the rest of the world for investing in the UK. For example: UK households buying shares in Microsoft will provide a net inflow of investment income in the form of dividends that is paid from Microsoft’s profits. This is treated as an export because it brings money into the UK. UK consumers buying cars manufactured by overseas companies will be an import, and the profits will go back to the country the car is manufactured. The level of net investment income in the UK is currently in deficit. 4. TransfersThe transfer of money represents: Sent to the UK from abroad. Sent abroad from the UK. The rise in immigration into the UK has resulted in a rise in money being sent from the UK to countries when the migrants have come from. The UK transfer deficit means money going out of the UK exceeds the money coming in, and immigrartion is a key factor in this.

The Exchange RateThe exchange rate is the price of one national currency in terms of another national currency and therefore measures the external value of a nation’s money.A rise in the exchange rate of a country's currency is known as an appreciation.This means that export prices are dearer, and import prices are cheaper.A fall in the echange rate of a country's currency is known as depreciation.This means that import prices are dearer and export prices are cheaper.

An appreciation of the exchange rate will cause the AS curve to the shift to the right because imports are now cheaper and this helps lower the domestic price level. Hence, a strong currency can help to lower cost push inflation by reducing the cost of imported materials and foods and energy.

A depreciation of the exchange rate will shift the AS curve to the left because imports are now dearer and this causes the domestic price level to rise. There a depreciating currency can be inflationary because it increases the price of imported materials, foods and energy leading to cost push inflation.