Do macroeconomic policies conflict?

Fiscal and supply-side policy
Increased government spending may be used as part of a fiscal policy to increase aggregate demand, and much of this spending will be directed towards the health and education sectors. In this case, fiscal and monetary polices are working in tandem to improve growth prospects, and the supply-side effects may cancel out any ill effects on the price level from the expansion in demand.

By contrast, if a government is using contractionary fiscal policy as a means of trying to control the price level, the impact may be a leftward shift in the AS curve, and therefore prices may rise rather than fall and output might contract even further than intended.

Fiscal and monetary policy
While these are both demand-side policies, if a government runs a budget deficit, this has to be financed which will affect the money markets. Much of the budget deficit is financed by issuing 3-month treasury bills, which offer investors secure and liquid assets which are easy to trade on the money markets. This helps with stability during a credit crunch, but at other times it might be inflationary as it increased liquidity available. A looser fiscal policy can mean that the MPC favours a tighter monetary policy, taking into account the fiscal stance in deciding whether to change interest rates.

Policy instruments

Demand-side policies

Demand-side policy is a deliberate manipulation by the government of aggregate demand in order to achieve macroeconomic objectives. There are two demand-side policies: fiscal policy, which is the government’s management of its spending and taxation with the aim of changing the total level of spending in the economy; and monetary policy, which is the decision making using monetary instruments such as the interest rate.

Fiscal policy
If government spending is greater than taxation, the government is operating a fiscal or budget deficit. The net effect is to pump spending power into the economy. The multiplier magnifies the effect of this boost. So, for example, if the government builds a new hospital and does not pay for it all through current taxation, but instead borrows to finance the scheme, there will effectively be more spending power in the future. When the government pays for the workers and building materials for this hospital, the incomes will be re-spent into the economy, creating more incomes – which is the multiplier in operation. If an economy is going through a slowdown or a recession, then according to Keynesian thinking, the government should spend its way out of the recession.

By contrast, if the government is spending less than taxation, there is said to be a fiscal or budget surplus, which take spending power out of the economy with negative multiplier effects. The consensus among economists is that in times of boom or fast growth in the economy, the government should rein in its spending to curb inflationary pressures. This is known as contractionary fiscal policy, and it puts the government accounts in a better position.

Does fiscal policy work?
In the UK fiscal policy can only be implemented in the annual budget, although there is some room for manoeuver in the autumn pre-budget report. This creates a time lag in decision making for fiscal policy, added to which there is an implementation lag because many tax changes cannot being until the start of the new fiscal year in April, sometimes one or two years ahead. This means that if the government tries to respond to current economic problems using fiscal policy, the effect will not become apparent until the economy has started to change tack in the normal course of its economic cycle. Furthermore, when a government deliberately sets out to expand its spending, people will try to cash in on this by expanding their pay demands, and the effect will be increased wages and costs, rather than expected output.

Next, there are crowding-out effects of increased spending by governments, For example, if a government tries to build a new hospital, there is less scope for a private hospital in the vicinity essentially providing the same service. There is also crowding out in a sense that when the government runs a deficit it needs to raise finance, which, in times when credit is less readily available, will stifle private initiative. However, it can be argued that expansionary fiscal policy simply causes inflation because the debt issued to finance the expansion, often Treasury bills, is so liquid that it acts like printing money.

Monetary Policy
The manipulation of monetary variables such as the interest rate has enormous implications across the whole economy. In the UK a group of up to nine economists forming the Bank of England’s Monetary Policy Committee, whose sole purpose is to control the level of inflation, makes the interest rate decision independent of government. They meet at least once a month for a day and a half to examine evidence from across the country relating to inflationary pressures. They have a target set for CPI inflation set for them by the Chancellor of the Exchequer, currently at 2% ± 1%. If inflation falls outside the range of 1-3%, the Governor of the Bank of England must write and open letter to the Chancellor to explain why this has happened. In the first 10 years of operation, this only occurred once when inflation reached 3.1% in MArch 2007, but has risen significantly above since May 2008. The most recent letter was about three weeks ago, when the CPI measured inflation at 3.7%.

Causes of inflation
In order to understand how monetary policy works it is important to consider the causes of inflation. In terms of AS/AS analysis, inflation can be shown as a shift to the right in AD, or a shift to the left in AS. A shift to the right in AS is often called demand pull inflation and it occurs whenever AD shifts to the right, usually exacerbated by the effect of the multiplier. A shift to the left in AS is known as cost-push inflation and occurs whenever costs of production increase in an economy. These might be for short term reasons, such as a fall in the exchange rate making imports more expensive, or for longer term reasons such as higher corporation taxes.

However, according to monetarists such as Milton Friedman, inflation is always and everywhere a monetary phenomenon’, meaning that inflation is caused by increases in the money supply about the rate of the increase in real output of the economy. Inflation can be controlled by controlling the money supply, either directly or perhaps more effectively though the rate of interest.

Costs and benefits of inflation
Monetary policy involves controlling inflation, whether too high or too low. To judge whether the policy is worth pursuing it is helpful to consider the costs of inflation and the possible benefits of a little inflation.

The costs of inflation include:

  • Loss of international competitiveness. Exports become relatively expensive and imports relatively cheap. The balance of payments is likely to worsen.
  • Redistribution of income. Those on fixed incomes will find incomes fall in real terms. Those with index-linked incomes will not loose out, unless linked to a fairly unrepresentative measure such as CPI.
  • Increased uncertainty. If firms think that costs are rising and fear increases in interest rates, they might curb investment.
  • Investment from abroad might decrease. Inflation erodes the value of money,  so why buy into a currency that is falling in value?
  • ‘Shoe-leather’ costs. The opportunity cost of spending more time withdrawing savings and holding less cash because of inflation.
  • ‘Menu’ costs. The money spent replacing signage, price labeling, and menus because of changing prices due to inflation.

Benefits of inflation might include:

  • Inflation reduces the real interest rate, so the cost of borrowing falls. Therefore, those with large debts such as mortgages will find their debt will fall.
  • Increased prices may be a sign that firms can make profits. So in contrast to the above point about uncertainty, it might mean that investment is encouraged.
  • A little inflation provides a cushion against the effects of deflation. When prices are falling in an economy, a vicious cycle of underinvestment and spending can occur.
  • A little inflation means that real wage differentials can be changed without actually cutting money wages. The argument is that people will accept wage rises below inflation, but not wage cuts.

How monetary policy works
When interest rates are raised, the cost of borrowing rises. Consumers who borrow in order to finance their spending might be deterred from doing so and savers will be less keen to spend their savings as there is a greater opportunity cost in doing so. People with mortgages – of whom there are almost 10 million in the UK – will find that their mortgage interest repayments rise, and will therefore be discouraged from spending, although those with fixed rate mortgages will not suffer this immediately.  Hire purchase – the method of buying major durable items, such as cars and white goods, on credit – will incur increasingly expensive monthly repayment installations, which means that consumers might delay further major expenditures.  House prices may fall as mortgages become less affordable, and this can cause negative wealth effects, where lower asset prices mean that people feel less inclined to spend and less able to take out loans based ont he equity of their homes.

Firms will find that investment is less attractive in many cases, and that fewer investments will make a return higher than the increased cost of borrowing. Therefore, firms will be less inclined to invest, which not only reduces current aggregate demand, but also has implications for long-term output prospects. The cost of exports might increase because interest rates are essentially a cost of production, so exports will fall and imports will rise. This is made even more likely when we factor in a very probable increase in the exchange rate, which occurs when ‘hot money’ is attracted to higher interest rates in the UK.

All these changes shift the AD curve to the left with multiplier effects. Depending on the shape of the AS curve, this may decrease both the price level and real output. Increasing interest rates can be an effective way of controlling inflation, but the cost is that economic growth also falls.

How effective is monetary policy?
Monetary policy has a shorter time lag than fiscal policy, although the MPC estimates that interest rate changes can take 18 months to 2 years to have their full impact. There are further delays because many mortgage holders have fixed-rate policies, which may delay the impact on their spending for some years. Furthermore, monetary policy is a very blunt tool that hits the whole economy, affecting both small and large firms, and rises in interest rates usually worsen income distribution. But perhaps the most significant criticism of monetary policy is that raises costs of production in a situation where the cause of inflation may be itself an increase in costs. So the rise in interest rates, rather than curing the problem, exacerbates it. In a time of rising commodity prices, the people who have to bear the brunt of this are those who have debts.

Supply-side policies

Supply-side policies include any action by the government intended to increase the amount that forms are willing to supply at any given price level. In other words, they seek to shift the AS curve to the right.

[diagram on page 51]

There are three basic ways of achieving this:

  • Increasing price flexibility and signalling in a market. If prices are not used to allocate resources effectively, there will be surpluses or deficits on the market. Suppose the government failed to increase the real rate of minimum wage: this means that real wages would fall and there would be less unemployment on the labour market. Firms’ real costs of production would therefore go down, and the AS curve would shift to the right.
  • Increasing competition. Reducing artificial constraints such as legal monopoly rights, as with the UK Post Office, can increase competition. As firms compete, they must either cut costs or become more innovative to survive, which effectively shits the AS curve to the right by reducing costs. Another way to increase competition is to privatise, although there is little scope left for privatisation of publicly owned firms in the UK. Deregulation is another option – this happened in the 1980s in the UK with the freeing up of the bus and coach operations sector.
  • Improving incentives. Incentives function by giving people higher rewards for what they do, and therefore motivating them to work harder. The most obvious way to do this is to vut marginal tax rates. Longer-term solutions involve improving health, education and training and introducing performance-related pay. Again, these will encourage forms to produce more at any given price level.

How effective are supply side policies?

While some supply side policies are clearly very effective – for example, deregulation of the phone industry has resulted in greatly improved standards in terms of price levels, after-care service and the like – there are some industries where there is either no opportunity for increased competition, or where the benefits are outweighed by the increased costs. For example, many people believe that increased competition in the NHS has merely resulted in increased managerial costs rather than improved efficiency.

Another issue with supply-side policies is the time lag. Some policies, most notably in education, can take many years to have any effect on production costs. If anything, in the short run costs may increase as there are less people in the labour market.

In addition, supply-side policies have side-effects on the demand side. For example, cutting taxes will have fiscal policy implications. Perhaps the most important aspect is that cutting minimum real wages and reducing trade union power affects lower-income earners adversely and disproportionally. However, effective supply side policies do have the benign outcome of both lower inflation and higher rates of economic growth.

Conflicts between objectives

In this post a limited range of conflicts have been chosen, although for each objective there are issues with every other objective. Some objectives, such as growth and employment, have ore in common than others, such as growth and the environment. THe degree to which there is conflict is a useful way to approach your evaluation.

Inflation and unemployment
Consider this scenario. You are running a restaurant and the head chef is asking you for a wage increase. He may be good at his job, but you are not keen to pay more for the same service because it will eat into profits. What do you do? If there were a selection of unemployed chefs eager and willing to take up the post, you would probably look to employ a replacement, at the same or possibly a lower rate than your current chef. If, however, chefs are in short supply, and the success of your restaurant relies on having a good head chef that you can rely on, you would be more likely to enter into dialogue with him to keep him onboard.

In other words, a shortage of labour in a specific field can cause wage pressures to build up. The net effect in the wider economy is that, as wages go up, people start spending more, the costs of production increase as labour is a major production cost, and inflation begins to rise. In other words, low unemployment or reduced spare capacity leads to higher inflation.

The basic analysis is the rationale for the Phillips curve, which was an observation of an apparent trade-off between unemployment and inflation in the UK between 1861 and 1913.

[phillips curve on page 45]

In practice, if a government tries to exploit this trade-off it is unlikely to have the desired result. For example, because of the transparency of a governments actions, if it tries to spend its way into reducing unemployment the most likely effect will be an increase in wages to absorb the government’s extra spending; that is, inflation. As inflation goes up, newly employed workers will soon realise their wages are being eroded by inflation and firms will realise they are not getting as much profit out of their workers because of inflation therefore any increase in employment is likely to not last in the long term. For these reasons, while the Phillips curve is an observable phenomenon, it is not necessarily a viable tool for a government.

Economic growth and the balance of payments on the current account
As an economy grows and incomes rise, consumers are likely to demand more imports and firm’s incentives to export will diminish, as it is easier to find eager customers in the domestic market. Therefore, economic growth is likely to worsen the current account. The main exception to this is export-led growth, where the driver of growth is an increase in the net export component of the balance of payments. Export led growth means that the balance of payments will improve as more goods and services are sold abroad.

A second reason why growth might not necessarily worsen the balance of payments is if the growth is caused by an increase in aggregate supply. For example, owing to decreases in costs or increases in investment, an economy will become more internationally competitive, meaning the economy can export more an import less while growing.

Increased employment and sustainable environment
If more workers are being employed, there is likely to be more congestion on the roads an more carbon use because of more factories, more manufacture and greater energy usage. In addition, as people’s incomes increase, workers are more likely to go abroad for their holidays, and most foreign travel will involve increased carbon emissions.

On the other hand, higher employment can mean that the government has more scope for taxation, and one spin off might be the opportunity to use green taxes, where taxation is specifically designed to reduce carbon use. For example, in the March 2008 budget the first year of road tax was introduced for new ‘gas-guzzling’ vehicles. The effect of higher employment also depends on wether the increase is in the manufacturing or services sector. As more people can work remotely in the service sector, it may be that an increase in employment has a minimal effect on the environment.

Economic growth and income redistribution
When an economy grows, incomes are most likely to rise at the top end of the income spectrum: for example, in the form of bonuses for sales executives. The effect is a widening of income equality. However, over time, people a the high-income end of the scale might employ people from lower income groups, such as domestic staff. Increased demand for low-skilled labour should eventually lead to increased wages. This is called the ‘trickle-down’ effect.

Nevertheless, many economists argue that, while there may be some transferred benefits of growth, there is a two-track labour market and those with low skills rarely benefit because, as skill shortages develop, immigration fills the gaps and the wages of low-skilled workers dont rise. Another counter argument is that, even if wage rise by a constant percentage for everyone, income inequality will still increase in absolute terms.

Inflation and equilibrium on the balance of payments
Low inflation should help to improve a balance of payments deficit on current account. Low prices relative to other countries will mean that exports become more attractive on world markets and imports are less attractive. However, if the balance of payments tends to be in surplus, control of inflation will not restore equilibrium in the sense of removing a surplus.

Furthermore, when one of the main objectives of macroeconomic policy is to control inflation, interest rates might be tighter than they would otherwise be. High interest rates often mean that the exchange rate rises: ‘hot money’ flows in, as funds move between international capital markets seeking the best interest and exchange rates. A strong currency makes a country’s exports less competitive and its imports relatively cheap, worsening its trade position.

Macroeconomic objectives of governments

There are six main objectives which governments generally wish to pursue:

  • increased economic growth (real rises in GDP)
  • control of inflation
  • reduction in unemployment
  • restoration of equilibrium in the balance of payments on current account
  • a more equal distribution of income
  • protection of the environment

The order of priority varies according to the politics of a particular government and institutional arrangements such as the Monetary Policy Committee. Some governments see the control of inflation as the most important macroeconomic goal. Others, such as governments with a socialist leaning, would focus on the redistribution of income an the reduction of unemployment.

Trends in macroeconomic measures
In the years since the last UK recession of 1990-92, the UJ has seen economic growth at a trend of between 2 and 3% per annum, and inflation hardly reaching 3%, although cost pressures from increasing commodity prices threaten to push inflation over the 3% ceiling at the time of writing.

Unemployment, as measured by the Labour Force Survey, has settled at just over 2.6 million (8%) in 2010, with the claimant count at a low of 1.52 million in April 2010.

The trade in goods of the balance of payments is currently recording a £100 billion deficit, while the current account deficit as a whole is £2 billion. The deficit is wider during periods of higher economic growth, wich as the late 1980s, early 2000s and 2005. THe UK has the third largest current account deficit in the world, after the USA and Spain. As the dollar has been falling against the pound this is expected to worsen, but as the slowdown is exported from the USA to the global economy, the current account is likely to see a degree of self correction. The pound has fallen against the Euro, which is by far the most important trading currency in the UK, and this is likely to lessen the deficit.

The distribution of income described on the national statistics website shows a widening durring periods of economic growth, but other factors that help to explain this uneven distribution include accelerating wages at the top end of the scale, a fall in male participation in the workforce, an increasing number of workless households, and changes in the tax and benefits system.

Perhaps the least achieved objective is the protection of the environment. Clear and unambiguous indications are given in national statistics of carbon emissions. The Kyoto Protocol, ratified by 170 countries (but excluding the USA), states that by 2012 the developed countries will reach a carbon emissions level 5% below their 1990 levels. Although the UK has seen some improvement, it is not on target. The EU Emissions Trading Scheme set up in 2006 has not yet led to a carbon reduction, but as the prices of permits rise this situation should improve.

While each of these objectives can have serious effects on economic agents if it is out of control, some clearly have a more immediate impact on people’s lives. For instance, unemployment not only means lost income byt can mean a long-term reduction in a person’s employability through loss of skills and training. However, it might be that the government cannot solve unemployment in the short term. Many economist believe that too much cushioning of the unemployed results in an inefficient labour market, and that competition and increased incentives for those out of work are a better approach to dealing with unemployment.

Similarly, inflation of 2% is not thought to be a problem, ans as long as incomes move in line with inflation there will be no serious side effects. Most people’s wages, and also student grants and pensions, are adjusted in line with inflation, and so reducing inflation below this point is not a priority. However, as inflation rises there comes a point where it erodes international competitiveness, discourages foreign inward investment, and causes income redistribution away from savers to borrowers to such a degree that it destabilising effects become a major concern.

A current account deficit on the balance of payments is of no concern to governments if there is enough trust in the capital markets and the value of currency. It is, however, a sign that a country may be overspending relative to it’s income and at some point the outflow of money will have to be compensated by inflows. The UK has international investments abroad with enormous earning potential, which may me an the balance will be restored uf the situation is left to itself (lassiez faire). Many economists think that the UK government should not try to rectify a current account deficit with demand management. However, most agree that supply side policies should be used to restore competitiveness in the long run.

Perhaps the most contentious of policy objectives is the idea of taxing the rich and giving to the poor. Some would argue that redistributing income from the rich to the poor through taxes and benefits is simply unfair, destroys incentives and reduces the work ethic. The main drawback with social expenditure is that is has little effect on reducing poverty; some argue that it can even create a ‘dependancy culture’. However, extreme poverty is debilitating and leaves potential workers caught in a cycle of weakness. They may be unable to sustain permanent employment at the available rates of pay due to personal circumstance, dependants, a lack of skills or the high cost of housing.

Economic growth

Actual growth can be defined as an increase in real GDP and potential growth as an increase in capacity in an economy. Measures of real GDP tend to fluctuate over the course of an economic cycle. During a boom, real GDP rises fast. In a recession, it falls for at least two consecutive quarters. During a slowdown, the level of GDP may be rising, but rising below the trend.

The difference between actual output and either the trend or potential output is known as the output gap. The second of these two ways of defining the output gap is shown in the diagram.

[diagram on page 38]

If the economy is growing faster than the trend, pressures will grow in the economy, such as tight labour markets, wage pressures and shortages of raw materia;s. This is referred to as a positive output gap. It may be a sign that the economy is overheating and the inflationary pressures might persuade the Bank of England’s Monetary Policy Committee to raise interest rates.However, if the economy is growing below the trend, there is likely to be spare capacity in the economy. This situation is known as a negative output gap. It means there is scope for a cut in interest rates, which is less likely to cause inflationary pressures.

Causes of actual economic growth
Economic growth can occur because there is an increase in one of the components of AD. Here are some examples. Increased consumption might occur becuase of increased consumer confidence or the availability of credit. Increased investment increases the level of growth, and is itself dependant on the level of growth (i.e. it has an accelerating effect on growth rates). Government spending on education or health might cause growth. Export-led growth has the added advantage of improving the current account of the balacne of payments.

Growth can also occur because of an increase in aggregate supply. This might happen because production costs fall – for example, labour markets might become more competitive thanks to immigration or an increase in the birth rate – or because of government supply side policy such as deregulation the markets (removing constraints that limit competition).

A shift of the AD or AS curve to the right should cause an increase in actual growth. However, if AD increases and the AD curve is crossing the the vertical part of the AD curve, the only effect will be higher prices, not increased GDP. Similarly, if AS increases and the AD curve is crossing the AS curve on its horizontal part, there will be no change in the equilibrium and there will be no change in price levels or output.

Causes of potential economic growth
Potential economic growth can only occur when the vertical part of the AS curve shifts to the right, increasing the amount that the economy could produce. Using another model, potential economic growth increases when the PPF shifts to the right.

Constraints on growth
There are several factors constraining growth:

  • Absence of capital markets. One of the main reasons why Latin America grows more slowly than the Asian subcontinent is that Asia has more credible and efficient capital markets. In many economies in sub-Saharan Africa, the interest charged on credit, if credit is available at all, is typically over 50%. One of the issues is the asymmetric information in credit markets, where the lender knows very little about the borrower and charges high rates to cover the enormous risk. The only people able to afford these high rates are likely to be among the more corrupt borrowers, which makes it even less likely that people will lend. The market then becomes a missing market, in the sense that there is no equilibrium price of credit where buyers and sellers can agree on a rate of interest.
  • Government instability. When governments are incompetent or lack transparency or strong political backing, the economy cannot attract investment and the currency might become unstable. The government might have a fiscal deficit which means that it has very little power to encourage growth.
  • Labour market problems. A shortage of skilled labour is  a major contraint on growth. As countries get richer, birth rates tend to fall dramatically in the long run this means that the labour supply will fall.  One of the most effective policies  for reducing this in high income economies is to allow increased immigration, although in low-income economies the exit of skilled workers (known as brain-drain) exacerbates the skill problems.
  • External constraints. Trade is a key driver of growth. Uneven access to world markets owing to tariffs and subsidies can prevent an economy from growing. Global recession or fears or terrorism also low down trade, as does volatility in exchange rate markets. Figures suggest that for every 3% growth in world trade there is a 1% increase in world GDP, and therefore anything that hold back international trade is likely to act as a constraint on growth.

Benefits of growth

Growth benefits employees, firms and governments in the following ways:

  • Employees. Incomes and wealth rise when there is economic growth. Standards of living rise as long as the costs of living do not increase at the same rate. In other words, real growth means that real incomes rise. Increases in growth can mean that wealth in the form of assets sch as shares and houses increases.
  • Firms. Firms tend to make more profit when there is economic growth. In times of growth, consumer spending usually rises, which means that firms sell more. As revenues and profits increase, firms can take on more workers and are more likely to invest. This increases future growth prospects.
  • Governments. When incomes and assets rise in price, people pay more income and capital gains tax. Governments also have fewer demands to pay unemployment benefits. So in times of economic growth the government is more likely to enjoy a healthier fiscal position.

Costs of growth

Despite the benefits listed above, growth incurs the following costs:

  • Income inequality. The unwaged and unskilled are less likely to benefit from increased incomes. While money might eventually ‘trickle-down’  to lower-income groups, there might equally be a two-speed economy where the incomes of some people accelerate, but the rest cannot get out of the low-skill ‘lane’. The type of production tends to change during periods of economic growth, so there is likely to be short-term unemployment for people who do not have labour market flexibility.
  • Environmental problems. Depletion of natural resources and external costs such as carbon emissions an other forms of pollution are likely to increase with economic growth. However, high-income governments can use their increased ta tax revenue to clean up the environment.
  • Balance of payments problems on the current account. With higher incomes, domestic consumers suck in more imports and there is less incentive for forms to export. However, if growth were export-led, the current account would improve.
  • Bottlenecks in the economy. When there is little spare capacity in the economy, factos of production such as skilled labour and fuel rise in price. Monopoly power might also develop, which can be used a a barrier to the entry of new firms. This can be shown by an increasingly elastic AS curve.
  • Social dislocation and stress. Higher incomes have to be earned. With increased pay there are usually increased responsibilities. There may be more travel and the need to move further afield as firms grow. However, with higher incomes people can often afford to work fewer hours, go on more luxurious holidays, pay for their children’s education, or retire early. So social life may or may not improve as the economy grows.
  • Problems of rapid growth. Rapid growth can cause short-term spikes in prices. If a country grows too quickly there might be bad planning, corner cutting and shoddy workmanship. However, rapid growth might just need time to settle down in terms of income distribution, and a strong government such as that in CHina can ensure that growth is planned efficiently.

Aggregate demand and supply

‘Aggregate’ means added together – the individual elements that were introduced in microeconomics. Aggregate demand and supply analysis brings together the amount that consumers wish to consume and the amount that firms wish to produce at any price level. Aggregate demand (AD) is the total planned expenditure on goods and services produced in the UK. Aggregate supply is the total planned output of goods and services. The equilibrium point where they meet determines the average price level and the equilibrium real output level. THe price level can be measured by a price index such as the CPI, and the output but real GDP.

The aggregate demand and supply model is perhaps the most useful tool for macroeconomists, because it gives reasons for changes in the important macroeconomic variables: when price levels increase this is inflation, and when output increases this is economic growth.

Aggregate demand
Aggregate demand (AD) is the total planned expenditure on goods and services produced in the UK. It comprises of consumption (C), investment (I), government spending (G), and exports (X) minus imports (M).

The AD curve is downward sloping. This is not because ‘people buy more things because they are cheaper’ – the most common misunderstanding about the AD curve. There are three ways to explain the downward sloping AD curve, any of which is adequate at AS:

  • Lower prices in an economy mean increased international competitiveness, so there are more exports and fewer imports. In other words, net exports are higher at lower prices.
  • The total amount of spending will be approximately equal whether prices are high or low because people have approximately the same amount of money to spend, so there area under the curve will be fairly constant. This is known as the real balance effect. If you plot a constant area, you will get a rectangular hyperbola.
  • At higher price levels, interest rates are likely to be raised by the monetary authorities. This means that investment, a component of aggregate demand, will fall and savings might increase.

The components of aggregate demand and their relative importance

Consumption, or spending by household on goods and services, is the main component of aggregate demand, comprising approximately 65%. It measures the amount that consumers wish to spend at various price levels. One of the key determinants of consumption is the confidence of the consumer, both in terms of job security and in terms of future income prospects. If customers are feeling confident, they are more likely to make large purchases which they can pay for in the future.
Another determinant is interest rates. Higher interest rates not only leave consumers with less spending money after housing costs, but also increase the cost of hire purchase. A third determinant is the housing market. When price accelerate, home owners can extract more equity from their houses, as discussed in an earlier post on the Wealth effect.

There is an inverse relationship between interest rates and the level of investment that firms tend to make. This is because increases in capital stock have to be financed, and there is an opportunity cost to that finance. Firms often borrow from banks to finance investment, so if interest rates rise, the cost of borrowing rises and firms are less likely to borrow, and therefore less likely to invest. However, investments are not solely based on interest rates,and some argue that the interest elasticity of demand for investment is very low. This is because investors are sometimes driven by other factors, such as confidence in future sales patterns, what their main competitors are doing, government incentives and regulations, and the prospects for future interest rates rather than by the current rate of interest.

A change in investment will change the level of aggregate demand, but a change in aggregate demand will also change the rate of investment. This circular relationship can be analysed by the accelerator, and although this is not required knowledge for the AS examination, it is a useful way of evaluating the role of investment.

Government spending
Government spending in the UK comprises almost 40% of all spending in the economy, totalling about £590 billion. Government spending need not equal tax revenue and the difference between them is know as a budget (or fiscal) deficit or surplus. The government can deliberately manipulate aggregate demand by overspending (runnign a fiscal deficit) when there is a slowdown in the economy and vice versa in a boom. Taxing more heavily in times of abundance is a useful way of putting brakes on an economy, although sometimes governments miscalculate the start of a downturn and cut taxes too early (as in the late 1980s). Similarly, net spending can be increased in a recession, which will reverse the effects of a demand deficiency.

Another factor to consider is the national debt – the accumulation of fiscal deficits over the years. He budget needs to balance over the course of the economic cycle, otherwise the government will accrue national debt. Interest payments have to be made on this, and if government continue to overspend there will be a cost for future generations. In the short run, however, there is some flexibility with the balance of the government’s accounts.

Assessing the impact of an imbalance in the flow of government income
The Keynesian view is that fiscal policy – that is, the deliberate manipulation of government spending and taxation in order to change aggregate demand – is a powerful tool in shifting aggregate demand, made much more effective by the working of the multiplier. In contrast, the classical economist’s view is that overspending by the government has a similar effect to printing more money – it is purely inflationary.

There is now some consensus that deliberate fiscal manipulation has a short-run impact, but only if wage demands and other cost pressures are kept in check. There is also much consensus that it is only really through supply-side policies that long-term improvements in equilibrium employment will be achieved, as the AS curves shift to the right. But as Keynes would say, ‘in the long run we are all dead’ that is by the time the unemployed become employable they will be past working age.

Net exports
Exports represent an injection into the circular flow of income, in that the money paid for goods and services sold abroad enters the domestic flow of income. Imports mean that there is an outflow of money, and exports minus imports gives the total movement of funds known as net exports. (If the value of imports is greater than the value of exports, this will be a negative figure, as in the UK). There are several reasons why the value of net exports might change.

First, consider a change in the exchange rate. If the exchange rate increases in value against other currencies, imports become cheaper and exports more expensive on world markets. Over time, people respond to these relative price movements and the demand for exports falls and the demand for imports rises. A stronger currency will worsen net exports , whereas a weaker currency will improve the figure.

However, in the short run the price elasticity of supply for exports and imports tends to be low – inelastic. This might be because contracts have been signed for specific deals in international trade, or because traded components are a very small percentage of firms’ overall costs. For example, an Italian importer of BMW Minis will agree a price in advance of delivery from the UK. If the pound gets stronger against the Euro, the price of the cars will still remain the same as per the contract. Price elasticity of demand may also be low because of a lack of available substitutes, as in the case of oil. Owing to the low price elasticity of demand of exports and imports, the initial impact of a change in exchange rate may in fact be opposite to the one described above.

A second major cause of changes in the value of net exports is changes in the global economy. For example, if there is a recession the USA, but the UK does not suffer a slowdown, the USA will buy fewer exports from the UK, and will be attempting to export more. Similarly, if there is inflation in the Uk, but not in other countries, net exports from the UK will worsen as UK goods become increasingly uncompetitive. A collapse in a stock market in another part of the world may also have direct effects on UK exports via wealth effects.

Thirdly, non-price factors, such as quality and after-sales service, are major determinants if net exports. Germany, for example, cannot compete effectively on price, bu the value of its exports exceeds that of any other country owing to its high quality of design and manufacture.

In summary, wh any of the components C, I, G or X rises, the AD curve shifts to the right. The same happens if imports fall. As a useful evaluation point, it is wise to consider the above analysis involves levels rather than rates. In the UK these components do not usually fall, but they many rise more slowly during an economic slowdown, which means the AD curve will still shifty to the right but by ever decreasing amounts.

[diagram on page 34]

Aggregate supply

Aggregate supply is the amount that firms are willing to produce at various price levels. It is largely influenced by productivity, which in turn is influenced by factors such as the costs of production, the level of investment, the availability and efficiency of factors of production and supply side policies.

There are two views of aggregate supply. The classical view is that in the long run an economy will operate at full capacity and there will be no unemployed resources in the economy: that is, the AS curve is vertical – perfectly inelastic. If there are any unemployed resources, the prices of these factors will fall until the surplus disappears.

By contrast, the Keynesian view is that the equilibrium level of output can occur below the employment level of output. According to this view, the AS curve has a backward bending L shape, with three distinct sections: spare capacity, bottlenecks, and full employment. The assumption behind this analysis is that an economy can be in equilibrium when not at full employment. In other words, demand deficiency means that unemployed resources such as labour will not find work if the economy is left to its own devices.

In section A of the next diagram, there is spare capacity. The economy can increase output without any cost pressures. This is because there an unused resources such as factories not working at full capacity, or unemployed labour. In this section, aggregate demand may shift to the right – for example, through fiscal policy – and equilibrium real output would increase without causing an increase in the price level. The situation is comparable to that of Japan over the last two decades, where there is a lot of scope for increased production byt unemployment persists in the long run.

[diagram on page 35]

Section B in the diagram is the bottlenecks section, where some constrictions in the supply chain cause cost and wage pressures to build up in some areas of the economy. This usually involves a certain type of labour which when in short supply can have its price bid upwards. An example concerns the shortage of construction workers associated with the 2012 Olympic Games. If aggregate demand expands in this section of the graph, then while economy with still grow, there will be some inflation.

Section C illustrates full capacity in the economy, All viable workers have to work, so if a form wants to take on more workers it will have to entice the away from other jobs by increasing wages. In this section of the diagram, if aggregate demand increases, although in the short run there may be extra spending, the long term effect will be increased inflation and no increased output.

According the the classical view, section C is the only part of the AS curve that occurs. The economy cannot be in equilibrium while there is unemployment. So, if unemployment does exist, it can only result from a short-run failure of the market or from mismanagement by government.

Shifts in the aggregate supply curve
Shifts in the aggregate supply curve occur when factors change which will affect most firms. Such factors might relate specifically to the cost of workers (labour market) or the way in which firms compete (product market). Let’s consider how changes in both markets might produce a rightward shift of the AS curve.

Labour market
In the labour market, a rightward shift in the aggregate supply curve could occur in the following ways:

  • Productivity gap closes. Productivity is output per unit of input, and if it increases relative to a country’s main trading partners then the productivity gap is said to be closing. For example, the gap is currently closing between the UK and France, so while the UK has a lower productivity than that of France, its productivity is increasing over time, which means that costs of production are becoming relatively less expensive in the UK compared to France. However, the gap is widening between the UK and the rest of its trading partners.
  • Education and skills improve. Increased spending on education and training should mean that a country’s workforce can produce more output per worker.  Education increases the value of the potential output. However, not all education achieves this end. It is not clear that a BA in MAdonna Studies, or a BSc in Surf Science has a major impact on the costs of production in the UK.
  • Health spending increases. An increase in resources in the health sector should mean that workers have less days off sick and are actie for longer – often beyond traditional retirement ages. However, spending on health might be absorbed into wage increases for staff in the health service, which would have little overall effect on the level of healthcare. Similarly, the majority of healthcare spending goes on the elderly or very young, neither of which are economically active.

Product market
In the product market, a rightward shift in the AS curve could occur in the following ways:

  • Sources of raw materials change. In a developed country like the UK most raw materials are imported, and if global competition increases, UK costs will fall. The costs of the imports depends on global demand pressres from other parts of the world as well as supply. If there is a global increase in demand for oil, for example, this will cause the costs of production to increase in the UK because oil is a major production cost in all UK firms.
  • Exchange rates fall. If the Euro fell in value relative to the pound, many costs would fall in the UK, meaning that aggregate supply in the UK increases.
  • International trade increases. As a country opens up to more trade, competition drives down prices and inefficient domestic firms give way to overseas firms with a comparative advantage. So, as globalisation develops, aggregate supply increases.
  • Technological advantages. Innovation and investment in new ideas tend to reduce costs for all firms. For example, widespread access to the internet increases competition among forms and also means that firms can be more streamlined. Buying a book, for instance, is now much cheaper online as there are fewer expensive retail outlets to maintain.
  • Regulation changes. There are many regulations in the UK economy which have been imposed to try and maintain a disciplined economy, for example in the post and telecommunications service. However, such industries have been increasingly deregulated over the past two decades to increase competition, which in turn imposes its own form of discipline. The net effect is that parcel postage and phone services – costs faced by all firms – have reduced in real terms, shifting aggregate supply to the right.

Income flows and wealth effects

Income flows
Imagine the economy as a simple model where there are just households and firms. The households hold all the factors of production – land, labour, capital and enterprise – and the firms are the producing units. Money moves from households to firms when they buy goods and services; and money moves back to households as payment for the use of the factors of production in the form of rent, wages, interest and profit. In this very simple model, known as the circular flow of income, money circulates from households to firms and back again, and the more that households spend and the more the firms produce, the higher the levels of incomes. It odes not matter which way you look at it, the income and output in the economy should always be the same, and they are measure by gross domestic product (GDP).

[diagram on page 29]

There are three leakages (or withdrawals) from the circular flow of income: savings, tax and imports. If you hide your money under your bed, the economy will slow down a little as there is less money in the circular flow. Similarly, if the government takes money in the form of tax, and does not spend it, or if people buy more things from abroad than they export, the economy will slow down as money leaves the circular flow. These three leakages effectively determine the size of the multiplier.

By contrast, there are three injections into the circular flow. These are investments – which is an increase in capital stock – government spending and exports. These all increase the circular flow and a change in any of these will be magnified by the multiplier.

The multiplier is the number of times a change in incomes exceeds the change in net injections that caused it. For example, if there is a £10 million increase in export values, the inward flow of money to the UK will be re-spent within the UK. Then the money is spent it will become other people’s incomes. THese incomes will be re-spent and so on.

The importance of the multiplier is that if there is any change in spending in an economy, the final impact on incomes will be much greater than the initial impact. The greater the leakages, the smaller the multipler. The formula is based on ow much of any extra pound earned is re-spent within an economy: that is, the marginal propensity to consume. The size of the multiplier in the UK is approximately 1.4, but in developing countries it is often higher, which partly explains their higher growth rates. For example in a country with a multiplier of 3, a net injection of $10 million will cause a $30 million increase in incomes in total.

If all the injections equal all the leakages, then the economy will be in equilibrium; if injections are greater than leakages, the economy will grow; and if leakages are greater than injections the economy will contract.

Wealth effects
Wealth is the sum of all the assets in the economy. In the UK, most wealth is held in the form of housing (almost 60%); the other major forms of wealth are stocks and capital assets. Wealth is a stock concept, whereas income is a flow concept – this means that wealth does not have a direct effect on the circular flow of income, but changes in wealth are likely to have an income on incomes and spending. For example, if you live in a property that increases in value, you might geel more confident about spending in the economy and your increased spending will then be part of the circular flow of income. Moreover, if houses become more expensive, someone could go to their local mortgage provider and request mortgage equity release; that is take out a loan based in the increased wealth. When that loan in spent, the circular flow increases. By contrast, when capital markets take a downturn in the USA< people living on pensions in the UK might find their incomes fall because dividends on pension funds are often based on the capital gains of shares.