Another Contribution to the Business Cycle

Read an interesting article on the BBC about the cost of bank holidays, according to research from The Centre for Economics and Business Research (CEBR).

Each bank holiday costs the economy £2.3m and that means the economy could gain an extra £19bn if bank holidays were scrapped. This can be a contribution to the business cycle (see here) because bank holidays reduce GDP. If the economy was suffering a downturn, the loss of GDP can cause the economy to worsen from a downturn to a recession. For the UK, especially at a time where we are not experiencing strong growth, forecasters are predicting the worst from the working days that are lost.

15% of the economy, which includes pubs, clubs, restaurants, cafes and visitor attractions, do well on bank holidays and 45% of the economy suffers, which includes offices, factories and building sites, where people do not go to work on the bank holiday. The areas that benefit do not balance out the loss of productivity from the services sector of the economy.

Do read the full article for more information.

Quantitative Easing (QE)

QE causes a change in the money supply. Steps:

1. The Bank of England (BoE) purchases assets such as government bonds and corporate bonds
2. Pays for these assets by creating money electronically and crediting the accounts of the companies that it bought assets from
3. These accounts are called reserves. All banks hold reserves at the BoE and the essence of QE is that it builds up these reserves
4. QE is likely to lead to inflation because banks lend more and increases the money supply (see Quantity Theory of Money). Another reason for inflation is, holding everything else equal (ceteris paribus), more people have more money that they supposedly use for consumption, creating demand pull inflation

Explained by Stephanie Flanders

http://www.bbc.co.uk/news/business-16973560

Stephanie Flanders in the BBC’s economics editor, the link above provides a short video RSAnimate of QE. A summary of the video is as follows:

·         The Bank of England creates money and spends it so that there is “extra cash” flowing into the economy. They spend it by buying government bonds or IOU’s (formal definition: documentation confirming that the debt is owed) from financial institutions such as pension funds or insurance companies.

·         This puts more money into the economy (higher money supply) because these financial institutions that sold these bonds have more money to spend on new businesses or on housing for example.

·         Because of this, it is cheaper for the government to borrow as the BoE pushes up demand for the Treasury’s IOUs and supply of bonds has been reduced. Long term interest rates are lower than they should be making it cheaper for everyone else to borrow as well, because higher demand means more spending and this leads to faster growth.

The last point explains the theory WHY the government uses QE even with the risk of inflation, particularly during recessions. If demand rises, consumption may increase and the economy begins to recover. 

Speculation

·     One of the factors that affect economic growth (see here), speculation is when the buying and selling activities of firms and individuals (known as speculators) affects the price of goods and commodities around the world.

·     Speculation can also influence the price of world currencies.

·     Before the crisis in 2007, the value of the pound rose significantly because interest rates were high prompting speculators to buy the pound because rewards for saving were greater.

·     Speculation can affect economic growth because of something known as the ‘speculative bubble’, relating to asset prices. Click on this link here for a more detailed analysis. Rapid growth of assets prices such as housing (e.g. 2007), commodities (gold, silver..) and shares/bonds can lead to a bubble because people speculate that the price will continue to rise so they buy more of these assets. When the price is above the real value of the asset, people will start to sell and the bubble bursts, leading to a collapses in business and consumer confidence and ultimately a recession.

The Credit Crunch

For those of you who are unsure what the 'credit crunch' is, and how it started, watch this simplified, but concise video that explains it.

http://www.youtube.com/watch?v=wGxmgwUWNr0&feature=related

To summarise, occurring in 2008, the credit crunch was the result of over lending to people who are high risk and thus the inability of debtors to pay back their loans. In a simplified version, banks make money through a process called credit creation, lending more than is initially deposited. They know that people will deposit money back into the bank that they borrowed from and so can afford to lend more than they have (given a low liquidity ratio: the proportion of their assets - savers' money - that they keep).

Code for Fiscal Stability (1998)

·     Based on the 5 principles of tax

o      Equitable

o      Economical

o      Efficient

o      Convenient

o      Flexible

Includes:

·     The Golden Rule

o      The government should only borrow to fund new social capital (capital spending, i.e. schools, roads…etc) and not current spending (e.g. welfare benefits)

·     The Sustainable Investment Rule

o      Public sector net debt should not rise above 40% of national income at the end of each financial year of the economic cycle

·     If the government stuck to the two rules, the public sector budget should, in theory, balance out over the course of one economic cycle because the government is not increasing current spending. A deficit is run on capital spending instead, thus balancing it out.

·     Aims

o      To limit how much the government borrows and for what purpose

o      Allow automatic stabilisers (see here) to smooth over the economy

o      Support the role of the monetary policy

o      Avoid an unsustainable increase in public sector debt

o      Ensure that tax revenues that are collected finance public spending as far as possible

·     Australia and New Zealand had a similar code

·     The government complied with the rules from the full economic cycle between 1997-1998 to 2006-2007, just before the recessions/economic crisis.

·     In November 2008, it was written in the pre-budget report that the code had been suspended to allow for the government to act appropriately in response to the global recession.

·     It was replaced by a less restrictive ‘temporary operating rule’ where the target was to manage public finances over the medium term. 

Please note, the Fiscal Policy Framework and the Code for Fiscal Stability should be used in the exam for demonstrating your understanding of past and previous fiscal policy used by governments. As it is no longer in use, be careful when mentioning in the exam.

UK Growth Figures

Today it emerged that the UK economy has grown 0.5% in the third quarter of this year. Economists predicted a 0.4% growth rate, beating expectations. My verdict: at least it's not negative growth!

These two articles here and here, are good readings explaining the recent ONS figures.

State of the World Economy

Just an article from The Economist about the future of the world economy. Worth a read. Print it out, highlight it...etc.

Here's the link:

http://www.economist.com/blogs/freeexchange/2011/09/world-economy?fsrc=nlw|pub|09-28-11|publishers_newsletter

Global Economy

For those of you who have been watching the news recently, you should know that there is fear that the global economy could double-dip which the USA in serious risk. Below is a summary of the main uncertainties the global economy faces.

The IMF says…

· There is sluggish economic growth

· Governments need to rethink their policies

· The UK growth forecast needs to be reduced (and George Osborne said so too). Economic growth in the UK has been revised to a mere 1.1%

· Deficit reduction plan needs to be delayed

Eurozone

· Italian credit rating degraded

· Protests in Greece

· 40% of our exports go to the eurozone.

All advanced economies are facing tough times.

The UK government should focus more on capital spending (spending on infrastructure). This will stimulate the economy because infrastructure provides the correct conditions for business and enterprise to flourish. It will create jobs in the short run and long run, and should increase economic growth in the long run.

It's good to be on the ball with all the latest economic news.

Word of the Day

Positive Output Gap

Occurs when an economy is producing above its trend rate of growth. The economy is said to be in a boom. Please see the economic cycle for more about positive and negative output gaps.

Word of the Day

Negative output gap

Occurs when the economy is performing below its trend rate of growth. For more detail, click here.

Word of the Day

Recession

A fall in national output (GDP) for 2 successive quarters or more. Recessions in the UK: 1980, 1990 and 2008 lasting two years or less.