The UK Economy: A Comprehensive Guide to Macroeconomic Performance

Posted on Aug 16, 2024 in Economy

MACRO Unit 2: The UK Economy

The performance of the economy has a major impact on people’s lives. It influences the types of jobs available, the goods and services available, and affordability.

The Government’s Macroeconomic Objectives

The UK government has four key macroeconomic objectives:

1. Low unemployment
2. Low and stable inflation
3. Sustainable economic growth
4. Balance of payments equilibrium

Key Economic Indicators

Several indicators illustrate an economy’s success:

1. Level of output and economic growth
2. Inflation rate
3. Level and rate of unemployment
4. Balance of payments

Generally, a growing economy signifies success.

Additionally, the government considers:

A more equal distribution of income

Protection of the environment and sustainability of growth

The Circular Flow of Income: Injections & Leakages

In a simplified, closed economy, households own all factors of production, which they sell to firms for financial rewards. These rewards enable households to make purchases.

However, this simple circular flow is too basic for practical use. In an open economy, three injections enter the circular flow:

1. Investment by firms (I)
2. Government spending (G)
3. Exports (X)

Each represents an autonomous addition to the circular flow of income. Conversely, leakages are withdrawals from the circular flow:

1. Savings (S)
2. Taxes (T)
3. Imports (M)

Transfer payments (TP) are payments received without a corresponding output level, such as unemployment benefits.

For economic equilibrium, injections must equal leakages. If injections exceed leakages, the economy overheats, potentially causing inflation. Conversely, if leakages exceed injections, the economy shrinks, leading to a downturn or recession.

Economic Growth

Economic growth is measured by Gross Domestic Product (GDP) or Gross National Product (GNP). GDP, the total output of goods and services produced domestically over a period (usually a year), represents the sum of all incomes earned and expenditures made in a year.

The preferred measurement, the expenditure method, considers consumer spending (C), government spending (G), firm spending (I), and net trade (X-M):

The Expenditure Method

C + I + G + (X – M)

For accuracy, subsidies are added, and taxes on goods are deducted, converting market prices to factor cost.

Converting Nominal to Real GDP

Nominal GDP, measured in monetary values, is influenced by inflation, potentially misrepresenting a country’s performance. Real GDP adjusts for inflation using a base year:

Real GDP = Nominal GDP x (Price index in base year / 100)

Example: Nominal GDP £1048 x (100 / 120) = Real GDP = £873m

While GDP per capita is widely used to measure economic performance and living standards, it has limitations. It doesn’t fully encompass the subjective nature of”standard of livin” and ignores factors like income distribution, the informal economy, public spending on health and education, negative externalities, and political freedom.

Factors Beyond GDP When Considering Standard of Living:

1. Birth rates
2. Mortality rates
3. Life expectancy
4. Percentage of the population in agriculture
5. Literacy rates
6. Number of doctors per capita
7. Distribution of income
8. Climate
9. Political freedom
10. Percentage of GDP spent on the military

Human Development Index (HDI)

The UN’s HDI measures national socio-economic development. Until 2009, it considered life expectancy, educational attainment, and adjusted real per capita income.

HDI Dimensions (Pre-2010):

1. Life expectancy at birth: Reflects population health and longevity.
2. Knowledge and education: Measured by adult literacy rate (two-thirds weighting) and combined primary, secondary, and tertiary gross enrollment ratio (one-third weighting).
3. Standard of living: Measured by the natural logarithm of GDP per capita at purchasing power parity (PPP) in US dollars.

HDI Dimensions (Post-2010):

1. Access to knowledge: Mean years of schooling and expected years of schooling.
2. Standard of living: GNI per capita (PPP US $)
3. Life expectancy at birth

HDI Limitations:

Economic Growth

Rising output suggests improving living standards. Real GDP is the most common indicator of economic growth.

Actual and Potential Growth

Increased productive capacity signifies potential growth, while increased output reflects actual growth. A PPF shift illustrates increased productive potential.

Movement from point A to B on the PPF represents actual economic growth. However, potential output can still increase from B to the PPF² boundary by utilizing unemployed resources.

Production and Productivity

Output can increase through greater resource employment or increased productive potential. However, increased productive capacity doesn’t guarantee increased output; it depends on whether actual output or employment levels match the increased capacity.

Output Gaps

Growth exceeding the trend rate, where AD outpaces LRAS, leads to a positive output gap, causing demand-pull and cost-push inflation.

Growth below the trend rate, where AD and actual growth lag behind LRAS and potential growth, leads to a negative output gap, causing unemployment and downward pressure on prices.

GDP Measurement Problems

1. Black Economy: Undeclared economic activity (e.g., cash-in-hand deals, illegal activities) creates a discrepancy between expenditure and income methods of calculating GDP, indicating the black economy’s size.
2. Non-Marketed Goods and Services: GDP excludes non-traded or unpaid services (e.g., homegrown produce, DIY, volunteer work).
3. Government Spending: Valuing non-sold government services (e.g., defense, police) based on production cost can be misleading, as productivity improvements might reduce costs and artificially lower their GDP contribution. To address this, the government estimates output using key performance indicators.

Costs and Benefits of Economic Growth

Benefits:

• Improved Standard of Living: Typically measured by per capita real income. Faster economic growth than population growth implies rising per capita incomes and improved living standards, as households can afford more. However, this view is limited, as GDP overlooks income distribution, the informal economy, public spending on health and education, negative externalities, and political freedom.

• Increased Tax Revenue: Higher economic growth can lead to increased tax revenue, enabling greater government spending on priorities like health and education.

• Higher Employment: Economic growth can boost demand, leading to increased employment.

• Increased Investment: Improved confidence, the accelerator effect, or higher profits can drive investment, leading to more capital per worker, higher productivity, and future growth.

Costs:

• Inflation: Increased demand without a corresponding supply increase can cause demand-pull inflation (e.g., AD2 and AD3 on LRAS1, raising average prices). Persistent wage pressures can lead to cost-push inflation.

• Depletion of Non-Renewable Resources: Using non-renewable resources for current production compromises future availability, potentially hindering sustainable growth.

• Environmental Costs: Increased output and consumption can lead to pollution, ozone layer depletion, and a greater need for landfill sites.

• Structural Unemployment: Economic growth can cause structural shifts, decreasing demand for certain skills and leading to structural unemployment.

• Stress & Psychological Problems: Professor Yew Nwang Ng suggests that economic growth can create competitive pressures for material wealth, potentially leading to stress, depression, and even suicide.

Sustainable Economic Growth

Governments aim for sustainable economic growth that doesn’t deplete scarce resources. Sustainability involves recycling, using renewable energy, and minimizing environmental damage.

Inflation

Inflation is a sustained rise in the general price level. Low, stable inflation maintains business confidence, while high inflation exceeding that of trading partners can harm competitiveness and trade.

The UK’s primary inflation measure is the Retail Price Index (RPI), which tracks price changes in consumer goods.

Calculating the RPI

The RPI is a weighted price index. The Office for National Statistics (ONS) uses the Expenditure and Food Survey to determine weights based on household spending patterns. Price changes for approximately 650 goods and services are collected monthly from 150 areas across the UK. The percentage change in price for each item is multiplied by its weight to calculate the RPI.

Other Inflation Measures

• RPI X: RPI excluding mortgage interest payments. This allows for international comparisons and avoids the distortionary effect of interest rate changes on inflation.
• RPI Y: RPI excluding mortgage interest payments, indirect taxes, and local authority taxes. This reflects underlying inflation, unaffected by tax or interest rate changes.
• CPI: Excludes housing-related items included in the RPI (e.g., council tax, mortgage interest payments, house depreciation). The CPI covers all households, unlike the RPI, which excludes the top 4% of income earners. It includes university accommodation and foreign students’ tuition fees.

The Bank of England targets 2.0% ± 1% inflation (previously 2.5% ± 1% until December 2003) using the CPI.

Inflation Measurement Problems

1. Quality Changes: Price indices don’t account for quality improvements (e.g., cheaper yet more powerful computers today).
2. Special Offers: The RPI doesn’t fully capture discounts or special offers, potentially understating inflation.
3. Changes in Expenditure: Annual weight reviews might not capture rapid shifts in spending patterns due to new products.
4. Sampling Error: The limited sample size of households surveyed (6,785) introduces potential sampling error.

Causes of Inflation

• Cost-Push Inflation: Increased production costs (e.g., higher wages, weaker exchange rate increasing imported raw material costs) are passed on to consumers as higher prices. This is represented by a leftward AS curve shift, raising prices to P₂.

• Demand-Pull Inflation: Increased AD (due to higher consumption, investment, government spending, or net exports) pushes against supply limits at full employment, causing price rises. This is shown by a rightward AD shift from AD to AD₁, increasing the price level to P₂.

Consequences of Inflation

Anticipated and Unanticipated Inflation

Anticipated inflation is predictable, allowing economic actors to adjust and mitigate harmful effects. Unanticipated inflation creates uncertainty, potentially reducing consumption and causing fiscal drag (e.g., higher incomes pushed into higher tax brackets due to unadjusted tax thresholds).

Generally, borrowers gain from inflation as the real value of debt erodes, while savers lose. State pensions, indexed to price changes, might lag behind faster-rising wages.

Costs of Anticipated Inflation

• Menu Costs: Businesses incur costs to update prices (e.g., reprinting menus, updating vending machines).

• Shoe Leather Costs: Higher inflation increases the opportunity cost of holding cash, leading to more frequent bank trips and increased transaction costs.

Costs of Unanticipated Inflation

• Distorted Market Signals: Inflation can mislead producers into perceiving increased demand when it’s just a general price level increase, leading to inefficient resource allocation.

• Uncertainty: Fluctuating inflation makes it difficult for businesses to predict costs and revenues, potentially discouraging investment.

• Redistribution of Income: Inflation can shift income from those on fixed incomes or with weak bargaining power (e.g., pensioners) to those who can secure higher incomes. Borrowers benefit, while savers lose.

• International Competitiveness: Inflation can harm export competitiveness while making imports cheaper, potentially worsening the trade balance unless the exchange rate adjusts, other countries experience higher inflation, or exports are not solely price-sensitive.

Accelerating Inflation

Accelerating inflation creates expectations of further price increases, leading to demands for higher wages, preemptive price hikes by firms, and increased consumer spending, further fueling inflation.

Employment and Unemployment

Unemployment reduces output below potential, decreases tax revenue, and increases welfare spending. It can lead to social problems like increased divorce rates, mental health issues, and skill degradation, making re-employment harder.

Unemployment Measures

The UK has two main unemployment measures: the claimant count and the labor force survey.

The claimant count, the number of people claiming jobseeker’s allowance, is easy to collect but potentially overstates unemployment. It doesn’t account for those not actively seeking work or those excluded from calculations (e.g., over 60s, under 18s, those on government training schemes).

The Labour Force Survey, based on the International Labour Organization’s (ILO) definition, includes those of working age who are without work, available to work within two weeks, and have sought work in the previous four weeks. This measure, aligned with international standards, allows for easier cross-country comparisons.

The Labour Force Survey, based on a survey of 60,000 households (100,000 people), typically yields a higher unemployment figure than the claimant count.

Unemployment Measurement Problems

1. Claimant Count Sensitivity: Changes in eligibility criteria for benefits directly impact the claimant count (e.g., excluding males over 60).
2. Labour Force Survey Representativeness: The surveyed sample might not be fully representative.
3. Genuine Unemployment Assessment: Determining whether those included in unemployment figures are genuinely seeking work can be challenging.

Consequences of Unemployment

Individual Consequences:

• Reduced Living Standards: Loss of earnings leads to lower living standards.

• Skill Degradation: Unemployment can lead to skill loss, hindering future employment prospects.

• Social and Psychological Costs: Unemployment can cause feelings of uselessness, social exclusion, depression, health problems, and lower life expectancy.

Economic Consequences:

• Fiscal Burden: Unemployment reduces tax revenue and increases welfare spending, potentially leading to budget deficits.

• Negative Multiplier Effect: Reduced demand for local goods and services can have a wider economic impact.

• Lost Output: Unemployment leads to lost output, potentially causing a negative output gap. Long-term unemployment can lead to hysteresis, where the LRAS shifts inwards due to skill atrophy and labor market detachment.

• Social Problems: High unemployment areas often experience increased crime, violence, and vandalism.

Balance of Payments

The balance of payments records all monetary transactions between a country and the rest of the world over a period. It comprises:

1. Current Account
2. Capital Account
3. Financial Account

The International Investment Position shows external assets and liabilities at year-end.

Current Account

The current account consists of:

1. Trade in Goods: Exports and imports of physical goods.
2. Trade in Services: Exports and imports of services (e.g., shipping, financial services, insurance, tourism).
3. Income Flows: Primarily investment income (interest, profits, dividends) from overseas assets (e.g., bank deposits, UK-owned companies abroad, UK-held foreign shares) minus income earned in the UK by foreign-held assets.
4. Current Transfers: Central government transfers (e.g., EU contributions, foreign aid), net remittances from migrants, and other payments not involving goods or services exchange.

Capital Account

This minor component includes government investment grants and transactions involving non-produced, non-financial assets (e.g., patents, trademarks, land for embassies).

Financial Account

Previously the capital account, this reflects flows of money entering and leaving the country (e.g., company purchases, foreign exchange transactions).

Net Errors and Omissions

This balancing item ensures the current, capital, and financial accounts sum to zero, maintaining the balance of payments.

International Investment Position

This account reflects the total value of external assets held by UK entities minus UK assets held by foreign entities.

Causes of a Current Account Deficit

1. High Domestic Income (Economic Growth): Imports, with high-income elasticity of demand, increase during economic booms. The UK’s high marginal propensity to import (MPM) exacerbates this effect.
2. Overvalued Exchange Rate: Makes exports less competitive and imports cheaper.
3. High Unit Labour Costs: High labor costs per unit of output (potentially due to low past investment and productivity) can make UK goods less price-competitive.
4. Poor Non-Price Competitiveness: Factors like quality, design, reliability, delivery times, and after-sales service can impact demand for UK goods.

When a Current Account Deficit Might Be Less Problematic:

• Short-Term Deficit Due to High Growth: Expected to subside as growth normalizes.

• Easily Financed Deficit: Covered by investment inflows on the financial account.

• Deficit Driven by Productive Imports: Imports of raw materials and capital equipment used for producing exports or enhancing productivity.

Policies to Address a Current Account Deficit

While options include reducing AD to curb import spending, devaluing the exchange rate, or implementing protectionist measures, the UK government favors supply-side policies to enhance competitiveness:

• Increased Investment: Lower corporation tax can incentivize investment, boosting capital per worker and productivity.

• Improved Human Capital: Increased spending on education and training enhances workforce skills.

• R&D Promotion: Tax breaks for R&D reinvestment encourage technological advancement.

Exchange Rates

Exchange rate systems can be fixed (determined by the government or an international body), managed (allowed to fluctuate within a band), or floating (determined by market forces).

Consequences of Unstable Exchange Rates

1. Planning Difficulties: Frequent fluctuations make it challenging for businesses engaged in international trade to plan, as the value of payments in domestic currency becomes uncertain.
2. Reduced Trade: Uncertainty about future exchange rates can discourage trade and encourage seeking cheaper imports.
3. Impact on Productive Potential: High exchange rates can harm exporters, potentially leading to business closures and reduced investment, as the likelihood of selling output declines.

Conflicts in Macroeconomic Policy

Simultaneously achieving all four macroeconomic objectives is challenging. For example, boosting AD to reduce unemployment can fuel inflation and worsen the current account balance due to increased imports. Conversely, reducing AD to control inflation can lead to higher unemployment.

The”stop-g” cycle describes alternating periods of economic stimulation and contraction as governments try to balance these objectives.

Governments often prioritize certain objectives over others. For instance, during high unemployment, increasing AD might be favored even if it leads to higher inflation, reflecting a trade-off between unemployment and inflation.

Aggregate Demand (AD)

Aggregate demand represents the total demand for goods and services in an economy. It comprises:

AD = C + I + G + (X – M)

Where:

The AD curve illustrates the relationship between output (real GDP) and the price level. It slopes downward due to:

1. International Competitiveness: Lower prices make exports more competitive and imports less competitive, increasing net exports and AD.
2. Purchasing Power Effect: Lower prices increase the purchasing power of disposable income, boosting consumer spending and AD.
3. Expectations: Low prices can create expectations of future price rises, encouraging consumers to bring forward spending and increasing AD. Conversely, high prices and expectations of future price declines can dampen demand.

Determinants of Consumer Spending

Disposable income (income after taxes and benefits) is a key determinant of consumer spending, the largest AD component. The marginal propensity to consume (MPC) is the proportion of additional income spent on consumption.

At low-income levels, the MPC is high, as additional income is spent on essentials. As income rises, the MPC declines as saving becomes possible. The very rich, with their needs already met, tend to save most of their additional income.

The consumption function illustrates this relationship:

C = a + (MPC x Yd)

Where:

• C = Consumption
• a = Autonomous consumption (spending at zero income, financed by borrowing, savings, or benefits, covering basic necessities)
• MPC = Marginal propensity to consume
• Yd = Disposable income

Other Factors Affecting Consumption:

• Government Policies: Changes in taxes, benefits, and pensions can impact disposable income and consumer spending.
• Interest Rates: Higher interest rates reduce consumer spending by increasing borrowing costs and mortgage repayments.

Determinants of Investment Expenditure

Private sector investment is influenced by:

• Interest Rates: Higher interest rates increase borrowing costs, making fewer investment projects profitable (represented by the Marginal Efficiency of Capital – MEC). Higher interest rates lead to lower investment and a leftward AD shift.

• Accelerator Principle: Firms increase investment in response to rising demand and national income to meet anticipated future demand. This leads to a rightward AD shift.

The accelerator principle is represented by:

I = a (Yt – Yt-1)

Where:

• I = Investment by firms
• a = Capital-output ratio (amount of capital required to produce one unit of output)
• Yt = Income in the current period
• Yt-1 = Income in the previous period

• Expectations “Animal Spirit”): Keynes emphasized the role of business confidence and expectations about the future, which can be influenced by various factors.

Determinants of Government Spending

Government spending is driven by economic policy objectives and political ideologies. Governments use spending to influence AD and can target specific areas to impact AS (e.g., infrastructure, education).

Determinants of Expenditure on Exports and Imports

• Exchange Rates: A stronger domestic currency makes exports more expensive and imports cheaper, potentially worsening the trade balance.
• Interest Rates: Higher interest rates can attract foreign investment, strengthening the domestic currency and impacting trade.
• Domestic Demand: The UK’s high MPM means that rising domestic income leads to increased import demand.

Aggregate Supply (AS)

Aggregate supply is the total output produced in an economy. The AS curve shows the relationship between total output supplied and the price level. It slopes upward because:

• Profitability: At low prices, firms are less willing to produce due to low-profit margins. As prices rise, production becomes more profitable, incentivizing increased output.

In the short run, price level changes cause movements along the AS curve. With spare capacity, increased demand primarily boosts output. As full capacity is approached, costs rise, and the AS curve steepens.

In the long run, factors shifting the entire AS curve (supply-side policies) include:

1. Education and training
2. Technological change
3. Increased labor and capital mobility

Supply-side policies aim to improve efficiency and productivity but often involve long time lags, uncertain impacts, and potential conflicts with other policy objectives.

Long-Run Aggregate Supply (LRAS)

Keynesian LRAS

The Keynesian LRAS curve has two segments:

1. Horizontal segment (A-B in Figure 6): Represents an economy operating below full capacity with unemployed resources. Increased AD primarily boosts output without significant price increases.
2. Upward-sloping segment (B-C in Figure 6): Represents an economy approaching or at full capacity. Further AD increases lead to price rises (inflation) as supply cannot keep pace with demand.

Keynesians believe that supply-side policies are necessary to shift the LRAS rightward (LRAS₁ to LRAS₂) and achieve sustainable growth without inflation.

Classical LRAS

The classical LRAS curve is vertical, reflecting the belief that the economy always operates at full employment. Any unemployment is considered voluntary, as the market would clear it if workers accepted prevailing wages.

Classicals argue that AD expansion (AD₁ to AD₂) only causes inflation (P₁ to P₂). They emphasize supply-side policies to shift the LRAS rightward (LRAS₁ to LRAS₂) for sustainable growth.

The Multiplier Effect

Changes in AD or AS can have a larger overall impact on GDP than the initial change due to the multiplier effect. The multiplier measures how an initial change in spending is amplified through the economy.

In a closed economy, the multiplier is calculated as:

Multiplier = 1 / (1 – MPC) = 1 / MPS

Where:

• MPC = Marginal propensity to consume
• MPS = Marginal propensity to save (MPS = 1 – MPC)

For example, if the MPC is 0.8, the multiplier is 5. A £200m increase in AD would lead to a £1,000m increase in national income.

In an open economy, the multiplier formula considers leakages (savings, taxes, imports) and injections (investment, government spending, exports).

The multiplier effect arises from successive rounds of spending. An initial increase in spending (e.g., government spending on education) leads to increased income for individuals (first-round effect). These individuals then spend a portion of their increased income (determined by the MPC), creating further demand and income for others (second-round effect), and so on. The process continues, with each round having a smaller impact due to leakages.

Understanding the multiplier effect is crucial for policymakers when assessing the impact of policy changes on the economy.

Macroeconomic Policy Instruments

Fiscal Policy

Fiscal policy involves adjusting government spending and taxation to influence AD and, indirectly, AS. Governments use fiscal policy to:

• Influence AD: Cutting taxes or increasing spending boosts AD by increasing disposable income and consumer spending. Conversely, raising taxes or cutting spending reduces AD.
• Impact AS: Targeting specific spending areas (e.g., infrastructure, education) or using tax incentives can improve productivity and shift AS rightward.

Automatic stabilizers, such as unemployment benefits and progressive income taxes, automatically adjust government spending and revenue in response to economic fluctuations, providing a degree of built-in stabilization.

Monetary Policy

Monetary policy, controlled by the central bank (Bank of England in the UK), involves manipulating interest rates, the money supply, and exchange rates to achieve macroeconomic objectives, primarily controlling inflation.

Monetary policy tools impact AD through various channels:

• Interest Rates: Lower interest rates reduce borrowing costs, encouraging consumer spending and business investment, thus boosting AD. Conversely, higher interest rates dampen demand.
• Money Supply: Increasing the money supply lowers interest rates and stimulates lending, boosting AD. However, excessive money creation without corresponding output growth can lead to inflation.
• Exchange Rates: Lower interest rates can depreciate the currency, making exports more competitive and imports more expensive, potentially boosting AD. Conversely, higher interest rates can appreciate the currency, impacting trade.

Supply-Side Policies

Supply-side policies aim to improve the economy’s productive capacity by addressing market imperfections and promoting efficiency. These policies often involve:

• Incentivizing Work: Reducing income taxes or providing work subsidies can encourage labor force participation and increase output.

• Education and Training: Investing in education and training programs enhances worker skills and productivity.
• Trade Union Reform: Policies aimed at reducing union power (e.g., restricting strike actions) aim to lower labor costs and increase labor market flexibility.
• Privatization and Deregulation: Transferring state-owned enterprises to the private sector and removing barriers to entry are intended to increase competition and efficiency.

Supply-side policies are generally considered long-term measures with uncertain impacts and potential time lags.

Application of the AD/AS Model

Macroeconomic policies are interconnected and can have unintended consequences. For example:

• Crowding Out: Increased government borrowing to finance spending can raise interest rates, reducing private investment.
• Exchange Rate Effects: Changes in interest rates or government spending can impact the exchange rate, affecting trade.
• Time Lags: Policy changes take time to impact the economy, with some policies having more immediate effects than others.

Policies to Reduce Unemployment

Fiscal and monetary policies can stimulate AD to reduce unemployment in the short run. However, this can lead to inflation, as illustrated by the Phillips Curve, which suggests a trade-off between unemployment and inflation.

Supply-side policies are seen as a way to address this trade-off by increasing potential output and reducing structural unemployment.

Policies to Control Inflation

Controlling inflation has been a primary objective for many governments in recent decades. Monetary policy, particularly interest rate adjustments, has become the favored tool for managing inflation.

Policies to Promote Economic Growth

Promoting economic growth is a key objective for improving living standards. Supply-side policies aimed at increasing the quantity and quality of factors of production are central to achieving sustainable economic growth.

Policies to Affect the Balance of Payments

The UK has experienced a Balance of Payments deficit in most of the last 20 years. However, the importance of this as a government objective in recent years has declined, in part because the deficit remains a very small proportion of GDP and also its growth is continuing to be managed.

In theory the best way to control a balance of payments deficit is to apply fiscal and monetary policies to depress the economy by cutting AD, and so cut imports. In the long-run supply side policies concentrating on an improvement of competitiveness could result in an increase in exports. This is a long process, which may coincide with other countries seeking to increase their competitiveness.

Unit 2 The UK Econom y 6EC02                       30                                    St Pau l’s School 2011