Inflation for January 2012

Inflation fell to 3.6% in January, as forecasters predicted. Read more on the Financial Times. The ease in inflation may give signs that this 'stagflation' that the economy has been experiencing may be shifting away. The coming months will tell how unemployment will change in response (Phillips Curve). Inflation faces downward pressure from the effects of higher unemployment, slow exports markets (due to the Eurozone) and lower energy prices (causing a rise in imports).

A further £50bn Quantitative Easing that the MPC authorised earlier this month shows that there is still deficient demand in the economy and it may continue to stay low. Thus economists are predicting more QE to keep inflation from falling below the government's 2% target.

Fiscal Policy video

Paj Holden's video on fiscal policy is a great material for revision or learning fiscal policy from scratch.

Key points/summary of topics explained

Fiscal policy - manipulating government spending and taxation levels in order to manage the level of AD in the economy.

Definition of AD (C+I+G+X-M)

In a weak economy (low AD), the government might consider loosening fiscal policy - lower taxes (boost consumption) and increasing government spending. Disadvantage of loose fiscal policy, if spending becomes too high, deficits rise, creating problems, such as the Eurozone crisis.

Explains the Euro crisis

Business cycle and output gaps

Note: The AD/AS diagram he uses shows the Keynesian LRAS (notes to come!)

Case Study: Greece

---> GDP growth of -6.6%

---> Budget deficit (2009) was 15% of GDP. In 2010, it was 11% of GDP and in 2011 it was 8% as a result of increased taxes and lower government spending (austerity measures). However the Greek government is still spending 8% more than revenues gained from taxation. There is also interest gained from the additional spending, demonstrating the importance of their fiscal constraints.


Quantitative Easing

Bad News for Britain

The UK's budget deficit (amount by which government expenditure is in excess of tax revenues) rose above £1 trillion (£1,000,000,000,000!) for the first time, in December 2011. This spells bad news for us because:

1. It means the government's deficit reduction plan is not working, which could mean deeper cuts for the rest of 2012.

2. The Eurozone crisis

Use this as a case study for what happens if the government uses Keynesian policies to increase economic growth (Labour's government policies....). Unemployment rose the same time as the deficit reaches an all time high, evidence for crowding out?

Government Policies to Reduce Unemployment

For government to use the correct policy to reduce unemployment, they must first recognise the cause of unemployment (see here). Using Keynesian fiscal policy to increase AD may be ineffective if structural unemployment is taking place, for example, since this will simply result in inflation.

Free market view

Government policies should only be aimed at reducing structural, frictional and real wage unemployment. Cyclical and seasonal unemployment can be resolved through the market mechanism. Setting markets free can encourage competition and enterprise culture, creating more jobs. Supply can create its own demand.

Keynesian view

The government should intervene to correct the market failure that causes unemployment. They should try to make markets function better, giving them a greater role that the free market economists believe.

Case Study – Government ‘Work Programme’

·       Aimed at reducing long term unemployment and tackling youth unemployment

·       It is a partnership with private companies

·       More information: http://www.dwp.gov.uk/policy/welfare-reform/the-work-programme/

Unemployment Notes

Full employment is, according to the Beveridge definition, when 3% or less of the work force is unemployed. At current, the unemployment rate is 8.4% of the labour force, indicating that the UK is performing far from full employment and full productive capacity. More detail can be found from notes published on 5th August.

The Natural Rate of Unemployment (NRU) is the rate of unemployment that occurs even when the aggregate labour market is in equilibrium (AD_L = AS_L). Below is a diagram illustrating NRU.

Point X is the equilibrium, AD_L = AS_L, the market going wage rate is W_FE and full employment occurs when E_FE workers are hired. AS_LN shows how many more workers are willing and able to work at different wage rates but cannot due to frictional (geographical immobility) and structural unemployment (lack of skills). The NRU can be calculated by E_FE – E₁.

NRU can also be linked with inflation. NRU is also known as the Non- Accelerating Inflation Rate of Unemployment (NAIRU). This means that it is the only rate of unemployment that does not alter the rate of inflation.

Causes of unemployment

·     Frictional unemployment relates to the time taken to find a new job, the period between switching from one job to another. Frictional unemployment is caused by:

Ø  Occupational immobility of labour: Workers need more time to switch between jobs because they don’t have new skills to offer new employers. Lack of training courses, for example, makes the search period longer. Along with that, the longer the search period, the less employable the worker gets because they are losing their employability skills (work ethics, behaviour…).

Ø  Furthermore, new employment practices such as laws on equality (race, gender, sexual orientation...) can prevent perfectly capable workers from finding a job. This is one case against government intervention in the economy.

Ø  Geographical immobility of labour: The difficulty of moving to another location to find a new job. For example, the North South divide in the UK means house prices are too high in the South where more jobs may be available. Other reasons that cause difficulties are family ties and attitudes towards moving to new and unknown locations.

Ø  Search theory of unemployment: Those who are unemployed will continue to look for the ‘right’ job, comparing their old job with the other jobs available, for example, pay, travelling distance….etc. Because of this, workers may reject job offers, leading to a longer period of unemployment.

·   Structural unemployment means that workers lose their jobs due to changes in the structure of the economy. For example, the UK’s economy moved from an industrial one in the early 1900s to one based on providing financial services now. This led to the loss of jobs in the manufacturing sector (read this article: http://www.guardian.co.uk/business/2011/nov/16/why-britain-doesnt-make-things-manufacturing?newsfeed=true).

·   Seasonal unemployment occurs because of changes in the weather. When the UK’s climate changes, it affects the agricultural and tourism industries, leading to job losses in the winter.

·   Cyclical unemployment is caused by deficient aggregate demand. Also known as Keynesian unemployment or demand deficient unemployment, the diagram below displays a fall in  AD_L after a fall in AD. This causes employment to drop from E_FE to E₂. See a more detailed explanation as posted on 3rd October.

·   Real wage/classical unemployment is caused by wage stickiness. Collective bargaining by trade unions (see here) causes wages to remain high, causing unemployment.

Ø  The diagram shows that point X is the equilibrium point. The real wage rate is W_FE and employment is E_FE. When trade unions cause the real wage rate to rise, wages become W₁. This causes an excess supply of labour because at W₁, E₁ workers are willing and able to work at this wage rate. However, demand for labour is only E₂, more workers are willing to work than firms wish to hire, thus creating unemployment equal to E₁ – E₂. W₁ is known as the disequilibrium wage rate.

Ø  Free market economists believe that labour market competitiveness would drive down wage levels in time, however trade unions cause wage rigidity preventing it from going back to equilibrium.

It is important to note that unemployment is a waste of human capital. The disadvantages of unemployment are shown in the table below.

One positive of unemployment that classical economists believe is that it brings a downward pressure on inflation. But that’s up to you to decide whether you agree and be sure to write your opinion in the exam. See tomorrow’s post on government policies aimed at reducing unemployment.

Discretionary Fiscal Policy

Using fiscal policy in response to economic conditions, e.g. a recession, to induce changes in the economy. Some economists say that discretionary fiscal policy can be a good way to reduce the volatility of business cycles. For example if economic growth is slowing and forecasters predict that a down turn/recession may occur by the next year, expansionary fiscal policy may be used to reduce the impact. However, forecasters' predictions do not always come true, thus giving the case against using discretionary. Also, effects of fiscal policy do not show immediately due to the time lag, thus there is danger of in fact worsening the economic situation than improving it.

Evidence of Price War

Following 16th October's post giving you an oligopoly case study, forecasters have predicted that over the Christmas period Tesco lost market share while Asda, Sainsbury's and Morrisons grew market share. This just shows how price wars can adversely affect companies within a market. The 'Big Price Drop' campaign was matched by Asda's '10% cheaper' and others from the competitors. However a counter-argument is that the price led to increased market share for all the major firms regardless that Tesco has lost.