Economics B > Theme 2, 2.5 The Economic Cycle > Flashcards
Theme 2, 2.5 The Economic Cycle Flashcards
Define Economic cycle
The tendency of national / global economic activity to fluctuate between boom, downturn, recession and recovery.
Define Boom
Rapid economic growth.
Define Soft landing
Occurs when the economy moves to a gradual downturn in growth after a boom, rather than into a recession.
Define Recession
A period of two consecutive quarters where economic growth is negative.
Define Stagflation
Stagnant or falling GDP with prices rising at uncomfortable rates.
Define Inflation
General sustained rise in prices.
Define Social Capital
Capital assets which are publicly owned, e.g. schools, roads, hospitals.
Define Shrinkflation
Prices remain the same, but quantity reduces, so consumers receive less for their money.
Define Leading Indicators
Are early signs of the direction of economic activity, e.g. state of confidence or capital goods orders.
Define Lagging indicators
Are measures which are slow to reflect the current state of economic activity. Unemployment levels are often a lagging indicator.
Define Dividends
Income received by the owners of businesses are shares.
Define Leakages
Are ways in which income escapes from the circular flow between households and firms.
Define Injections
Are additional to the circular flow from source other than households.
Define Aggregate demand
Measures the total demand from all sources in the economy.
Equation for Aggregate demand
AD= C+I+G+(X-M)
Define Capital goods
Owned by government, are productive assets, acquired by investment, which are expected to make a contribution to future output.
Define Aggregate demand curve
A diagram representing the total level of demand in the economy at different price levels.
Define Aggregate supply curve
A diagram showing total quantities of output in the economy at different price levels.
Define Supply Constraints
Occur when demand for scarce resources increases, forcing prices upwards. These include people with scare skills ( labour), natural resources that have a finite supply ( land and commodities), and financial resources.
Define Inflation
An increase in the general level of prices within an economy.
Define Deflation
Is a period when the rate of general price level falls i.e. the cost of a basket of goods and services is becoming less expensive. Rate of inflation falls below 0%.
Define Disinflation
When the rate of inflation decreases - so prices are still increasing but at a slower rate.
Define Index Numbers
Index numbers take data for a period of time ( called time series data) for each year, the index gives the percentage from the base year.
Calculating Changing inflation.
Difference / Original times 100 = %
Define Real Values
Shows the actual change in the cost of living taking account of inflation e.g. changer per price - inflation rate.
Define Nominal Values
Show changes in prices at current prices without modifying for inflation.
Define Demand-pull inflation
Caused by changes in the level of aggregate demand in the economy.
Define Cost-push Inflation
Caused by changes in the costs of production.
Define Structural unemployment
Occurs when demand for the product is falling because of changing consumer preferences or competition from imports or newer products.
Define Technological unemployment
Occurs when labour-saving equipment and other new techniques reduce the need for labour.
Define Geographical unemployment
Refers to the ability of workers to move from one area to another.
Define Occupational unemployment
Their ability to move from one type of work to another.
Define Seasonal unemployment
unemployment varies throughout the year. Jobs in some areas depend on the time of the year.
Define Frictional unemployment
Occurs when people have left one job and take a short time to find the next one.
Define Claimant count
Measures unemployment by counting everyone who claims Job Seekers’ Allowance (JSA).
Define The labour force survey (LFS)
Bases its data on samples of the population, and suggests higher totals than the claimant count. It includes people who are not in work, are available for work and seeking work, but not receiving JSA.
Define Employment
Means being economically active, (able and willing) normally in a paid role. Self-employment is included.
Define Unemployment
Someone of working age and available for work, ( able and willing) but with no job.
Define Underemployment
When people who want full-time work can only find part-time, or skilled and qualified people can only find unskilled work.
What is the economic cycle?
Refers to the stage of economic prosperity and decline
Which stages of the economic cycle are inflationary?
Booms and recoveries
Which stages of the economic cycle are accompanied by government spending?
Recessions and slumps
What stage of the economic cycle would tax revenue be the highest, and why?
Booms, Aggregate demand is high, firms produce more units of output so pay more corporation tax, and consumers earn higher wages so pay more income tax.
When do consumers and firms have the lowest levels of confidence?
During economic slumps
Name the 3 injections and 3 withdrawals to the circular flow of income.
Injections: exports, investment, government spending.
Withdrawals: imports, savings, taxes
When does the economy reach the state of equilibrium?
When the rate of withdrawals = the rate of withdrawals
Income=___________=___________
Income= Output =Expenditure
List the components of Aggregate demand
Consumer spending, Investment, Government spending, Exports-imports
Which is the largest component of AD?
Consumer spending.
Define disposale income
Income left over for consumers to spend once taxes have been deducted.
How do low interest rates encourage more consumer spending?
Low interest rates make it cheaper to borrow money and discourage saving.
They also lower the cost of variable rate mortgages, increasing disposable income.
What are the only 2 things consumers can do with income?
Save it
Spend it
How do business confidence and capital investment correlate?
As confidence increases, so does capital investment
Is fiscal policy demand-side or supply-side?
Demand-side
When would the government initiate contractionary fiscal policy?
During economic booms, in order to ease inflationary pressures and prevent any periods of economic stability.
How would the exchange rate affect the current account deficit?
A depreciation in the pound (£) makes imports expensive and exports cheap, thus narrowing the deficit and boosting economic growth
How could the government intervene to reduce the current account deficit?
By adopting protectionist measures, whereby tariffs against imports increase and British firms are subsidised to improve their competitiveness
List 4 factors affecting aggregate supply
- Cost of employment
2.Cost of raw materials
3.Government Regulation
4.Migration
Which way would the SRAS curve shift given an increase in taxes.
Shift to the left (i.e. a decrease in supply)
Which way would the SRAS curve shift given a decrease in the cost of raw materials?
Shift to the right (i.e. an increase in supply)
Define Inflation?
A persistent increase in the general price level of goods/services over a period of time
How does deflation differ from disinflation?
Deflation is a fall in the general price level, whereas disinflation is a fall in the rate of inflation.
What is the target inflation rate?
2%
Briefly describe the Consumer Price Index?
A survey is used to find a weighted basket of goods. The prices of these goods are measured and updated annually.
How does the Retail Price Index differ from the CPI?
The RPI includes housing costs, and therefore generally has a higher value than the CPI
Describe the difference between nominal values and real values.
Real values take into account the rate of inflation.
What type of inflation is caused by exchange rate depreciation?
Demand-pull inflation
When does the cost-push inflation occur?
During an inward shift of aggregate supply, whereby firms face higher costs.
What type of inflation occurs when workers demand higher wages?
Cost-push inflation
How does inflation benefit those in debt?
the value of debt erodes over time with inflation, so consumers don’t have to pay back as much.
How would inflation be a burden on firms?
Workers would see their real income erode when accounting for inflation, therefore they would demand higher wages which would increase costs for firms
How does someone unemployed differ from someone economically inactive?
Unemployed are those who are able to work and actively seeking a job, whereas those economically inactive choose to remain out of a job.
How does the Claimant count work?
This counts the number of people claiming unemployment-related benefits
What is the main disadvantage of using the Claimant account?
Many of those unemployed don’t claim benefits, as they have partners on high salaries
What 2 things does the Labour Force Survey ask?
- If the subject has been out of out work for 4 weeks.
- Whether or not the subject can start work within 2 weeks.
Briefly describe structural unemployment
Occurs when there is a mismatch between skills provided and skills required
Economic cycle: Long term trends (notes)
The long term trend rate of growth for GDP (the main measure of national income) in Britain is around 2.5%
per year. By contrast, China averaged GDP growth at over 10% a year for almost 30 years. The economy underwent rapid industrialisation, implementing new technologies, starting from a very low base. Many in the Chinese labour force moved from agriculture to manufacturing, where productivity is generally higher.
Since 2008 there have been many changes. The 2008 financial crisis affected nearly all economies. There was a sharp fall in UK GDP. In China the growth rate fell very little, though since 2011 it has fallen to
around 7%; it may fall further as more people move into the service sector.
The economic cycle notes
When we talk about a trend, we ignore
fluctuations which are an important feature of developments over time. Economies rarely grow (or decline) at a consistent rate. For example, from 2000 until 2007 in the UK there was relatively steady growth. In 2008 output fell so fast that it took six years for GDP to recover to 2007 levels. These fluctuations are part of the economic cycle.
The slow down in 2008-9 might have
happened anyway but it was made worse by the financial crisis.
Boom (unstable growth) notes
When people are optimistic and expectations are high, consumers are likely to spend more and firms will
be more inclined to invest. Growing demand encourages firms to produce more and investment adds to
productive capacity.
Faster growth can ‘snowball’ in a boom. Firms seek to increase output as demand is increasing, so employment will be high. Competition for skilled employees may involve pay increases. Unemployment will
be low and confidence and a ‘feel good factor’ make people ready and willing to spend more. In the UK and In the USA, one feature of a boom is that people borrow more to finance more spending, so debt increases.
If demand grows faster than businesses can increase output, demand will exceed supply. We call this unsustainable growth. Prices are likely to go up because both demand and costs are rising. Demand from borrowers can push up interest rates. The Bank of England can use higher interest rates to combat rising inflation (explained in Chapter 19). If this succeeds in gradually reducing demand, the boom may turn into a gentle slowing of the growth rate. This is known as a soft landing. The alternative is a more abrupt end to a boom. ‘Shocks’ such as oil and food price increases or a ‘credit crunch’ (as in 2008) can also dent expectations and change behaviour.
Downturn (cooling down) notes
People who become pessimistic, particularly about their current or future income, are likely to spend less; consumer demand in the economy will fall. If entrepreneurs also become pessimistic and cut investment plans (or abandon projects), this reduces their demand for labour, premises, plant and equipment. When sales are slow, businesses will pile up stock or cut output. Shocks (such as sudden oil price increases) can
increase the problems if they coincide with a downturn. Falling incomes, rising prices and difficulties borrowing tend to leave consumers with less real spending power, so demand for many products will fall.
In 2008, the downturn came when mortgages became hard to obtain, causing demand for house buying to fall. This followed a period of excessive lending which created a bubble of fast rising prices. Banks were in trouble as they had made loans which could not be repaid. The banking crisis spread a mood of gloom
and made borrowing very difficult.
Recession (Falling investment) notes
If firms cut output they will use fewer resources, including labour. If earnings fall and unemployment rises, household incomes will fall. A fall in incomes gives people less to spend and might spread pessimism. With less consumer spending, firms have less reason to invest in expanding capacity; they may even slow down replacement of ageing equipment. Thus investment spending is likely to fall, leading to a downward spiral as unemployment rises and incomes fall.
Falling activity in the economy leads to recession. The strict definition of a recession is two or more successive quarters of falling GDP. A fall in GDP for a single quarter could be a statistical blip. When GDP falls for two successive quarters, we see firmer evidence that total output has fallen; in a sense the economy
is going backwards.
Downturn (unemployment) notes
The silver lining in this situation is that at times of rising unemployment and falling incomes, inflation is commonly low. People with stable incomes are really no worse off. It is possible to combine high unemployment with high inflation in a situation known as stagflation. Businesses have to contend with falling sales
and rising costs. The impact on households will depend upon the comparison between changes to their
income and changes in the prices they pay. This has not been a problem for the past 20 years, but that
could change.
Recovery (confidence revives) notes
Recessions tend not to go on indefinitely. Eventually, change, such as a technological breakthrough, successful government action, a simple shift in consumer confidence, or businesses being forced to invest as old capital equipment fails, has always sparked a recovery from the trough (low point) and an upswing.
Sometimes, a technological breakthrough improves products or cuts costs, giving an irresistible spur to new investment. For example, advances in computer technology, or discovery of new and effective drug treatments for serious illnesses, could help. Confidence and expectations can be given a boost by any good news, perhaps even by a politician whose promises sound convincing. Governments can also take positive
steps, increasing spending to create jobs and increase incomes, whilst also completing valuable projects
such as improvements in social capital.
Recovery ( confidence revives) notes 2
Whatever causes a turnaround, incomes and spending will rise, improving prospects for firms so that they
invest, bringing positive growth and recovery. An upward spiral can gather pace and lead towards a boom.
Given that the trend rate of growth for the UK economy is around 2.5% per annum, 4% growth in a mature economy like the UK might indicate that the economy is overheating. (Emerging economies with 10% GDP growth are catching up and may be able to sustain that rate of growth for some years.) If demand grows
too fast for supply to keep up, inflationary pressure is likely. Rapidly rising prices can be part of a mixture leading to a downturn.
The economic cycle notes :How has this worked in the UK?
In 1989, the economy overheated. Inflation was accelerating; the government
introduced policies to slow the economy down and failed to achieve a soft landing. Then for 15 years the economy bumped along the long-term growth trend. So benign was the economic climate that people began to call it the Great Moderation. In fact confidence was so strong that borrowing had increased far
too much, and the financial system had taken very big risks.
The economy cycle notes: Animal spirits and expectations.
British economist John Maynard Keynes, whose ideas shaped policies in the mid-20th century, developed
complex theories but also used simple ideas. He used “animal spirits” to describe how the state of mind of producers and consumers had significant consequences for the economy.
The term captured the illogical nature of some mood swings. More recently, expectations have received considerable attention. The terms
‘expectations’ and ‘animal spirits’ are distinct but overlap; both essentially relate to mood. Mood plays a significant role in the economic cycle.
The economic cycle notes: An alternative view (profit seeking)
Some economists favour the free market system but see weaknesses in it that cause instability. Hyman Minsky’s theories received little attention 50 years ago when fresh, but recent experience has increased interest in his work. He pointed out that financial institutions which lend money are profit seekers. After a crisis, banks and others are cautious, only lending to those who can afford interest and repayments. Over time they become more confident and lend to borrowers who can only really afford the interest. Eventually they lend even to people who can afford neither interest nor repayments. At some point there is a ’Minsky moment’ when people realise that there are unrepayable debts. Panic selling sets in and leads to a crisis and recession. The cycle then starts again.
The sub-prime mortgage loans which were involved in sparking the last crisis and recession were precisely Minsky’s third type of lending. Although some economists spotted the problem long ago, it was only around 2010 that Greece’s inability to service its debts was widely recognised, leading to their economic crisis. Such evidence suggests that the financial instability Minsky described is one reason for crises and recessions.
Boom
Some economists favour the free market system but see weaknesses in it that cause instability. Hyman
Minsky’s theories received little attention 50 years ago when fresh, but recent experience has increased
interest in his work. He pointed out that financial institutions which lend money are profit seekers. After a
crisis, banks and others are cautious, only lending to those who can afford interest and repayments. Over
time they become more confident and lend to borrowers who can only really afford the interest. Eventually
they lend even to people who can afford neither interest nor repayments. At some point there is a ’Minsky
moment’ when people realise that there are unrepayable debts. Panic selling sets in and leads to a crisis
and recession. The cycle then starts again.
The sub-prime mortgage loans which were involved in sparking the last crisis and recession were precisely
Minsky’s third type of lending. Although some economists spotted the problem long ago, it was only around
2010 that Greece’s inability to service its debts was widely recognised, leading to their economic crisis. Such
evidence suggests that the financial instability Minsky described is one reason for crises and recessions.
Boom
Employment: High
Skills shortages: Frequent
Inflation: Accelerating
Confidence: Strong
Investment: High
Downturn
Employment: High, Falling
Skills shortages: Diminishing (gradually less)
Inflation: Slowing
Confidence: Low, Falling
Investment: Slowing
Recession
Employment: Low
Skills shortages: None
Inflation: low or negative
Confidence: very weak
Investment: Very low.
Recovery
Employment: low, rising
skills shortages: Beginning
Inflation: Stable
Confidence: low, rising
Investment: Growing
The economic cycle notes: Leading and lagging indicators (forecasting)
Businesses and industries are affected by the economic cycle in different ways. Leading indicators show what changes may be approaching. Falling confidence may suggest a downturn. As businesses lose confidence, investment is likely to fall, indicated by fewer orders for capital equipment. Share prices and
housing purchases may fall.
As our key measure of recession is GDP, falling GDP is central to recession. It is also normal to see falling capacity utilisation, falling consumption and lower wage and price increases.
The economic cycle notes: Leading and lagging indicators (Time lags)
Unemployment data is typically a lagging indicator, meaning that it is some time into a recovery before unemployment falls (often 12-18 months). Businesses need to be sure that demand will increase before recruiting new employees.
The economic cycle notes: The impact of recession on firms (inferior goods)
The impact of recession is uneven. Inferior
goods, with negative income elasticities of
demand, are likely to gain sales as people ‘trade down’. Organic food was steadily building its share of total UK food sales until 2008. As real incomes fell, many shoppers switched back to cheaper food from organic.
However, British
tourism gains if people can no longer afford foreign holidays. Necessities may face relatively little impact. We need to eat and would be reluctant to give up other aspects of our lifestyle which we see as necessary. Luxuries may suffer
bigger sales reductions. Champagne sales might fall in a recession. Numbers of people eating out in expensive restaurants are likely to fall; cheap takeaways may become more popular. The theme parks in the case study illustrate the impact of the economic cycle clearly.
The economic cycle notes: The impact of recession on firms ( Housing)
The housing market might seem more linked to necessity than luxury, but people tend to trade up to bigger houses during a boom. Falling house prices may indicate wider problems. In this century there has been growth in the buy-to-let market; buying a second or subsequent house to rent out may lead to capital gains. The buy-to-let market could stall if prices are no longer rising or if fewer people can afford high rents. Falling house prices are obviously bad news for builders. If fewer people move, there are knock-on problems for furniture and other consumer durables such as fridges and microwaves.
Advance planning can soften the impact of a recession on turnover and profits. Supermarkets, for example,
can emphasise their ‘value’ brands and market their necessities vigorously. Producers of luxury products
might have little alternative but to cut costs to survive a difficult period, unless they can switch some of their resources to necessary or inferior products. Even in a recession, though, there are opportunities. It is not only accountants specialising in bankruptcy who do well when the overall level of demand is falling.
The circular flow of income notes (factors of production)
In the economy there is a two-way relationship between firms and households. Most adults work for a
business (even if self-employed). They supply labour in return for payment. Others may own savings which yield interest, or businesses or shares in a business, yielding dividends, or land or property, from which they receive rent. Labour, capital and land, the factors of production, are all sources of household income in the form of wages and salaries, interest, dividends and rent. respectively.
The circular flow of income (money flows)
This relationship is important in economics, and a little more complicated than it might first seem. Money can leak out from the circular flow, or be injected into it, by households, businesses and the government.The first leakage is saving (S). Many households don’t spend everything at once; they save for a future big purchase, for retirement, or as a precaution to cope with future uncertainty. Some income goes in tax (T) so is lost to households. Some spending is on imports (M), so payment goes overseas rather than to UK firms. All three are leakages.
Alongside household spending, there are injections into the circular flow. If firms invest (I) they make payments to other firms and to their employees – as in the example of Hitachi above. Government spending (G) transfers money to households or directly to firms. British firms sell services and goods abroad, earning a flow of payments for exports (X).
The circular flow of income ( leakages and injections)
Leakages: Savings(S), Taxes (T), Imports (M).
Injections: investments (I), Exports (X), Government Spending G)
The circular flow of income (leakages and injections) 2
Once leakages and injections are added, it is easier to see how activity might fluctuate. Bigger total leakages would reduce the flow and bigger total injections would increase it. Changes to leakages and
injections can have a bigger (multiplied) effect on the flow of income. When Hitachi workers in Newton Aycliffe buy things from other local businesses it creates revenue for those businesses, which will increase
the incomes they pay, which will mean more income for other households… and so on.
The circular flow of income notes: Aggregate demand (consumption)
● Consumption (C)
Household spending on goods and services is the largest single component of aggregate demand. Incomes have a major influence on how much people spend, though borrowing and saving mean that there is not a precise match between incomes and spending. Saving has the opportunity cost of immediate
consumption, and is influenced by factors such as expectations and interest rates as well as income.
The circular flow of income notes: Aggregate demand (Investment)
● Investment (I)
Investment is our name for spending on capital goods to increase future productive capacity. Businesses invest for future profit. Current levels of demand are one indicator of potential future profitability. For example, a business with more orders than it can handle can find investment and expansion attractive.
Confidence and expectations influence investment; so do interest rates, which show the cost of borrowing to finance investment. (This is an opportunity cost even if firms use their own funds.) We sometimes distinguish between gross (total) investment and net investment which excludes replacement investment.
The circular flow of income notes: Aggregate demand (Government expenditure)
● Government spending (G)
Governments spend directly on goods and services (e.g. hospitals, teachers, weapons) and indirectly by paying grants and benefits to businesses and households (e.g. pensions). The amount raised by taxation and other means has an influence on government spending. However, the total of accumulated public sector (government) borrowing is over 80% of GDP, so past (and current) governments have spent more than their incomes.
The circular flow of income notes: Aggregate demand (Exports and imports)
● The balance of trade (X - M)
When British goods and services are exported, this is UK economic activity but not UK spending, so exports are added to domestic demand. The level of spending in other countries and the exchange rate are two influences on the level of exports. In the same way, buying imports means that part of our spending
is on goods and services from outside the UK, so these are subtracted from UK aggregate demand. In the UK, imports often exceed exports so there are trade deficits.
The circular flow of income notes: Aggregate demand (Equilibrium)
The economy is said to be in equilibrium when leakages are exactly equal to injections. In this situation there are no extra injections to add to spending power and encourage economic growth and no extra leakages that would cause demand to fall and economic activity to shrink.
The circular flow of income: Aggregate Supply (Spare Capacity)
Just as aggregate demand measures the level of demand in the whole economy, aggregate supply measures the total output from all activities. The aggregate supply curve (AS) is a way of showing the link between the general price level and total output. This plots the total quantity of goods and services businesses and
others in the economy are willing to supply, against the general price level.
When firms have spare capacity and idle resources, a price increase will not be needed to encourage them
to produce more. At low output levels, we can expect aggregate supply curves to be at or near the horizontal. At the other extreme, when output is close to full capacity, nearly all available resources are in use. Firms cannot supply more and the aggregate supply curve will be vertical. Bottlenecks will arise in some sectors of the economy before others, so we should see a curve rather than a 90 degree turn. Often
these bottlenecks will be caused by skill
shortages. Attracting people with scarce skills will mean offering better pay.
The circular flow of income: Aggregate supply (Full employment)
A shock such as a sharp oil price rise will shift the AS curve upwards, whereas a fall in costs will shift it down. An increase in capacity will shift it to the right; this could reflect increased investment, improved productivity, enhanced
human capital or technological change.
Economic growth should shift the aggregate supply curve to the right, as productive capacity increases.
The circular flow of income: The interaction of supply and demand (Supply constraints)
When we put aggregate demand and supply curves together, we get a picture of the current state of economic activity. Low aggregate demand, for example, is likely to be linked with limited inflation but also unused (unemployed) resources. High levels of aggregate demand will push the economy towards working near its full capacity, but often at the risk of accelerating inflation.
AD1 might represent a recession and AD2 a boom. Notice that at all levels of output up to EQ1, it is possible to expand output without having any effect on the price level.
However,if aggregate demand increases from AD1 to AD2, attempts to increase output towards EQ2 will encounter bottlenecks (a point of congestion in a production system that slows or stops progress) and cost increases. Hiring extra employees may require pay increases, which will increase costs of production and businesses will want to raise their prices to cover these. It will be possible to raise prices and still sell products because
incomes will be rising and consumers will be able to increase their spending. If many economies are expanding together, pressure on resources (in
particular, oil) will tend to push up prices globally, especially for products that are not unlimited in supply. We call such issues supply constraints.
Inflation: Inflation jargon (Prices)
We usually talk about inflation rather than the price level because our standard expectation is that prices and the cost of living move up more than down. So money loses some of its value and can purchase less. When we measure price changes each month
the answer is normally positive. The rate at
which prices rise (inflation) varies considerably, but months when the general price level falls (such as April 2015) have been rare
in the UK.In the past
inflation has disrupted the UK economy
seriously, several times. Yet Japan’s experience shows us that deflation is not good either. This is why many central banks aim for 2% inflation.
In April, there was deflation – just. The general price level fell. More often, we see disinflation, meaning a fall in the rate of inflation. If inflation falls from 5% to 4%, there is disinflation.
Inflation: Price indices ( measuring price changes)
Inflation is measured by collecting thousands of prices every month, and turning the findings into an
index number. The Household Expenditure Survey uses a ‘basket of goods’ to reflect typical spending
patterns; over time new items are added to the index and others drop out. Tablet computers are a fairly recent addition, sales of wallpaper paste fell and were dropped in 2014. The items used to construct the index number are weighted to reflect their relative importance in spending. A car owner may occasionally buy engine oil, for example, but will spend more on petrol or diesel. Most months some prices fall and others rise; the index averages this out. As each month’s new figure is added, data from 13 months ago
drops out to give an annual rate.
Inflation: Price Indices ( measuring price changes)
Index numbers always have a base year, with the value 100. Table 19.1 uses index numbers to show changes in UK inflation. Index numbers are important because they make it easier to compare changes in different variables. If inflation rates for a number of economies are all displayed as index numbers you can easily see how they differ.
This data is exactly the same as the data in Figure 19.1, but displayed differently. Figure 19.1 is all about changes over time in the UK. Table 19.1 could be used to compare UK inflation rates with those of other economies.
Inflation: Price Indices (CPI and RPI)
The main indices in current use in the UK are the consumer price index (CPI) and the retail price index (RPI). The CPI excludes mortgage payments and tax changes; it tends to give a lower figure than the retail price index. The expenditure survey’s ‘basket of goods’ reflects typical spending, but different groups will have different spending patterns. For example, many households have mortgages, but others pay rent or
own their homes outright. It is possible to construct more specific price indices, for a particular region or for groups such as pensioners. The CPI and RPI are used in different contexts, but both give a reasonable indication of the rate of inflation and how it changes.
Inflation: Real and Nominal values (Current and constant prices)
If you live in an average house, it is worth around £200,000, depending on the region you live in. In 1952, the average house was worth around £1,500 (Nationwide data). Today’s house is not 13 times as good. If it is modern, it probably has smaller rooms and a smaller garden, for example. On the positive side, it probably has central heating and better insulation. But the price difference is mainly due to inflation.
If wages rise by 5%, it doesn’t mean workers are 5% better off than last year. If prices have gone up 3%, then real incomes have gone up 2%. Only their nominal or money income has gone up by 5%. Looking at data involving money over time, we usually need to separate out the effects of inflation. When we use
real data, we mean we have removed the effect of inflation to look at real changes in quantities. Nominal data is usually described as being at current prices; real data is at constant prices. The table heading will include something like ‘at 2010 prices’ or ‘base year 2010’.
In the case of economic growth for example, changes in real GDP tell us much more than changes in nominal GDP. In the UK nominal GDP tends to rise faster than real GDP because we have inflation. When
Japan had deflation, both real and nominal incomes fell, with real incomes sometimes falling faster.
Inflation: Causes of inflation (Cost inflation)
Thinking in terms of aggregate demand and supply, changes in inflation can either be because cost changes have influenced aggregate supply or because aggregate demand has shifted.
Cost increases shift the AS curve upwards. However much is supplied, prices will have to rise, to cover the
new, higher costs. We call this cost-push inflation. The three usual suspects when this happens are rising prices for oil and other commodities, wage increases and a fall in the £sterling which makes all imports more expensive.
The absence of inflation early in 2015 was largely due to lower global oil prices. Oil is particularly important as most things are transported and various products (such as plastics) use oil as a raw material. In a globalised economy, we are vulnerable to cost increases which can be completely beyond our control.
Inflation: Causes of inflation (Demand inflation)
If aggregate demand rises above the maximum possible output, the likely result is overheating and
demand-pull inflation. UK consumers are fond of spending whenever their confidence is not low. On
average they spend more of their income than Asian consumers, for example. Many UK consumers spend
more than their income, running down their savings or getting into debt. Investment and export booms would be welcome, but consumption is the main determinant of aggregate demand.
Inflation: The impact of inflation on firms (Uncertainty)
When the rate of inflation is high or fluctuating, there is significant uncertainty relating to future costs, prices and revenue, and also about the availability of investment finance. All this damages confidence, resulting
in reluctance to invest and a more cautious attitude to any risk. If interest rates are kept above the rate of
inflation, to maintain positive real rates of interest, there will be anxiety about the likely cost of borrowing.
The comparison between the rate of inflation and the growth of money incomes is significant. For all but
inferior goods, a business should be helped if incomes at least keep up with prices. But demand for many goods will fall if inflation reduces spending power. Many businesses will have stocks or spare capacity and will compete more strongly because they cannot all sell everything they produce. In general, businesses will try to pass increased costs on to consumers if they can. Depending on the type and cause of inflation, some firms will often have bigger cost increases than others.
Inflation: The impact of inflation on firms (wage-price spiral)
Employees’ wage expectations will partly be shaped by the inflation rate. Workers are very aware that they will become worse off if their incomes do not keep pace with prices. Wage increases for employees are cost increases for the business. A bout of inflation can turn into a wage-price spiral if big wage increases cause most firms to raise prices and the fresh inflation causes more wage demands. Generally, though, firms have fewer problems with demand-pull inflation than cost-push.
Inflation: The impact of Inflation on firms (loss of competitiveness)
An economy with higher inflation than its trading partners faces problems too. If home suppliers compete with imports, higher inflation lifts the prices of home produced goods, making imports relatively cheap.
Imports are likely to rise and many home producers’ sales will fall. Exports are also likely to fall.
They become more expensive in overseas markets than the local substitutes, and so less competitive. This
combination means less profit for firms in a country with inflation, and perhaps fewer jobs if output has to be cut. The size of these problems will depend on the price elasticity of demand for the product concerned.
Inflation: The impact of inflation on firms (Depreciation)
Falling exports could reduce foreign currency earnings and rising imports would mean more demand for
foreign currencies to pay for them. Rising supply and falling demand should push down the value of the home currency. This could offset the effects of inflation on import and export prices. It would make exports cheaper abroad, improving competitiveness again.
Similarly, imports would become more expensive and domestic producers would be able to compete more easily. However, firms using imported materials
and components have higher costs when foreign currency gets dearer.
Inflation: The impact of inflation on individuals (Fixed incomes)
Not everyone will get pay rises that keep pace with inflation. Anyone with a fixed money income will lose as prices rise. Their purchasing power falls, so real income (the goods and services an income can buy) falls. Some senior citizens rely mainly on private pensions paid for during their working lives. If their pensions are fixed in money terms, they become poorer during inflation. UK state pensions and some occupational
pensions are index linked, rising annually in line with a price index. These pensioners lose out only if the
prices of what they buy rise faster than the basket of goods in the expenditure survey. This is not a trivial point; many pensioners spend heavily on heating, for example.
Inflation: the impact of inflation on individuals ( Real incomes)
Many workers will keep up with inflation; some might find their pay increasing faster than prices. Not everyone will do so well. More than a third of UK workers are in the public sector. In the period 2009-13 they had a wage freeze followed by a 1% limit on increases. They had lost more than 10% of their real incomes by 2015.
Inflation: The impact of inflation on individuals ( Debts shrink)
House price inflation has frequently been greater than general price increases, to such an extent that
mortgage repayments have frequently cost people less than they gain from the increased money value of houses. Anyone who has a debt in money terms will see the real value of their debt fall when there is inflation. Savers, by contrast, often receive less in interest than the rate of inflation, so the real value of their savings falls. The biggest debtor in most countries is the government. Inflation helps governments by reducing the real value of past borrowings.
Inflation: The impact of inflation on individuals.
Overall, inflation redistributes income and wealth. (Wealth means total assets.) Those who can secure pay
rises faster than price increases will gain, gain more if they also have debts, and gain again if they also have
assets such as property which goes up in price. Those who are in a weak bargaining position or have fixed
money incomes will lose. The extent of the problems this will cause depends on the rate of inflation. Some
countries have experienced hyperinflation, with prices going up by more than 50% per month. In Zimbabwe
in 2008, the inflation rate rose above 50 billion %. Savings were wiped out, some people starved and money
effectively ceased to function.
Employment, unemployment and underemployment: Employment concepts and jargon ( Changing employment patterns)
Students are not unemployed if they are committed to full-time study. Pensioners are not unemployed if they have retired. People who stay at home are not unemployed if they are not available for paid employment. The term unemployment applies to people who are available for employment, but have no job.
The nature of work is changing and making the situation less clear. Many people are employed part-time
rather than full-time, perhaps at more than one job. There are now ‘portfolio workers’ who switch between tasks and employers rather than stay in one role. Whereas an actor is unemployed when there is no work, for example, someone who chooses to work part-time is not really unemployed on days off. The average amount of time for which people stick to one type of work, for just one employer, has fallen. This reflects
an increased pace of economic change.
Inflation: Employment, unemployment and underemployment: Employment concepts and jargon ( Changing employment patterns) 2
Many part-time workers would prefer to work full-time if a job was available, but can’t find a job. These
people are not unemployed but they are underemployed. People who are skilled and qualified but can
only find unskilled work are also underemployed in a sense, as their ability is not fully used. (Cheyenne
could easily have found herself in a situation like this.) From a national perspective, unemployment and
underemployment mean that labour resources are underused. Unemployed and underemployed people
face various difficulties.
If demand is growing unsustainably fast and employers are having difficulty recruiting the people they need, overfull employment may develop. This may be a consequence of having too few people with the required skills. It may not be a thing of the past.
Employment, unemployment and underemployment: Measuring unemployment (claimant count)
The claimant count measures unemployment by counting everyone who claims Job Seekers’ Allowance
(JSA). It does not include people who take alternative benefits such as disability allowance, or have no benefit entitlement – rules on claiming have been tightened up. This suggests that the claimant count underestimates true unemployment. Some cheats say they are seeking work when they are not, to qualify for benefits; this increases the claimant count somewhat.
Employment, unemployment and underemployment: Measuring employment (LFS)
The labour force survey (LFS) is an alternative measure, which bases its data on samples of the population, and suggests higher totals than the claimant count. It includes people who are not in work, are available for work and seeking work, but not receiving JSA. This survey, also known as the ILO (International
Labour Organisation) measure, is normally used when international comparisons are made.
The July 2015 issue of LFS data estimated
that 1.85 million people were unemployed in the UK, 5.6% of the workforce. 30.98 million people were in employment. The unemployed are included as part of the UK ‘working
population’ of nearly 34 million, despite not currently being in work. The claimant count gave a lower total of just below 5%
unemployed. Like most data, these estimates give a plausible picture of the situation but not a precise and totally accurate view.
Employment, unemployment and underemployment: Causes of unemployment (structural unemployment)
Changing tastes and consumption patterns, or changing international specialisms, can reduce the need for
certain types of work; this produces structural unemployment. Many traditional manufacturing industries have seen structural decline. Some of their workers (e.g. drivers or accountants) have transferable
skills which can be used elsewhere. Skills specific to one industry are not transferable.
Employment, unemployment and underemployment: Causes of unemployment (Technological unemployment)
Technological unemployment is caused by advances which enable firms to operate in new ways that
involve less labour. This can be treated as a type of structural unemployment but has a distinct cause. The
product is still made and sold, but jobs are lost. Automated robots on car production lines have reduced
the number of assembly line workers. Self-service tills leave fewer jobs for supermarket checkout operators.
Manufacturing and primary industries give the most obvious examples of technological unemployment, but many service industries are affected too.
Employment, unemployment and underemployment: Causes of employment (structural and technological)
Technological unemployment is caused by advances which enable firms to operate in new ways that
involve less labour. This can be treated as a type of structural unemployment but has a distinct cause. The product is still made and sold, but jobs are lost. Automated robots on car production lines have reduced the number of assembly line workers. Self-service tills leave fewer jobs for supermarket checkout operators.
Manufacturing and primary industries give the most obvious examples of technological unemployment,
but many service industries are affected too.
Employment, unemployment and underemployment: Immobility (retraining)
Problems with structural unemployment are increased by occupational and geographical immobility.
Inability to transfer skills to another use is at the heart of occupational immobility. If highly skilled workers become structurally unemployed, shifting to new work is harder for them than for the unskilled; they face
a bigger fall in income and a loss of seniority. Geographical immobility arises from social ties which make it hard to leave an area, and from housing market issues such as regional price differences and the costs of moving. Retraining can help with occupational immobility. Many recruiting employers offer help to offset
moving costs.
Employment, unemployment and underemployment: Causes of unemployment- demand deficiency (Recession)
In a recession or a downturn in the economic cycle, aggregate demand in the economy is relatively low.
With declining sales opportunities, businesses might need fewer employees and this can lead to redundancies. These job losses bring cyclical or demand deficiency unemployment.
In a deep recession with a significant fall in GDP, the level of unemployment can be very extensive. Falling incomes for the unemployed leave many households with less to spend, leading to further reductions in consumption. This in turn has a negative impact on investment spending, taking aggregate demand in the economy lower again and placing yet more jobs at risk.
Employment, unemployment and underemployment: Causes of unemployment (seasonal and frictional unemployment)
Whereas structural and cyclical unemployment can be long term problems, some job losses are shorter
term. Construction activity is slowed by midwinter weather and tourism peaks in the summer. Farmers need
most workers for the harvest season. Many retailers do best around Christmas. Seasonal unemployment
typically peaks in February.
People seeking a move for promotion, or just a change of scenery and workmates, will often have a gap between jobs. This type of short run unemployment is known as frictional.
Employment, unemployment and underemployment: The impact of unemployment on firms (Redundancy)
When cyclical unemployment reduces sales and revenue, firms must take difficult decisions about
redundancies. ‘Letting people go’ is expensive in the short term and can damage morale throughout the
organisation. When business recovers it can be difficult to find suitable new staff to fill the gaps left by redundancies. In the last recession, many firms chose to put employees on shorter hours, sometimes asking them to accept lower pay, instead of redundancy. Even if labour costs are cut, fixed costs remain, despite reduced output.
Employment, unemployment and underemployment: The impact of unemployment on firms (Easier recruitment)
In a dynamic economy some firms thrive while others struggle, just as a few firms will fail during a boom. When other industries are involved in structural or cyclical decline, firms which are not directly affected may gain an advantage. There may be people seeking work after redundancy, which will alter the balance
of supply and demand in the labour market. Recruiting should become easier and existing workers may push less hard for wage increases.
Structural change may be shrinking a whole industry, but the most competitive firms may survive, masking the unemployment problem. Only with hindsight do some structural declines seem inevitable. There is a temptation to hang on to the end rather than switch to something with a better future. Sometimes there are niche markets for traditional British products which allow some firms to carry on when most others close. More often, the pace and power of change force industrial decline and resources have to be redeployed elsewhere.
Employment, unemployment and underemployment: The impact of unemployment on firms (falling demand)
Rising unemployment usually reduces consumer spending power. Producers of inferior goods may then do
well but producers of luxuries often face falling sales revenue. The extent of the problem depends on the
income elasticity of demand for the product.
Employment, unemployment and underemployment: The impact of unemployment on individuals
Rising unemployment makes it harder for job seekers to find work – there are fewer vacancies. Benefit levels are normally lower than wages, so unemployment means lower income, reducing spending and running down savings. People with commitments such as mortgage payments can face great difficulty. Society loses from having workers idle rather than contributing to output; the loss is greatest for the
unemployed.
Employment, unemployment and underemployment: The impact of unemployment on individuals (weak morale)
Psychologists say that most of us base some of our self-image and self-respect on what we do and our
contribution to the household and society. Not surprisingly, rates of depression are high amongst the
unemployed and probably also the underemployed. Research evidence shows poorer diets, higher infant
mortality, higher disease levels and lower life expectancy in workless households. Children living in such
situations will miss out on many educational and life opportunities.
Employment, unemployment and underemployment: The impact of unemployment (loss of skills)
Where people are unemployed for long periods of time, there is a danger that they will lose work habits (such as getting up at a regular time). Their skills will become increasingly dated and cease to match current requirements. Such ‘deskilling’ complicates attempts to bring long-term unemployed people back
into work. Unemployment amongst 18-25 year olds is more than twice the average for all age groups. Under-25s who have never had a real job have lifetime disadvantages.
Most people want to be actively employed. The circumstances which bring unemployment are often
beyond the control of those made redundant. A small minority choose to survive on benefits rather than
work. There are also people with unrecorded casual work who claim benefits whilst unofficially employed.
Estimates of the numbers involved vary widely. Surveys show that the total is lower than many people think. Various measures implemented since 2009 have reduced the numbers considerably.
Employment, unemployment and underemployment: The impact of unemployment on individuals ( being marginalised)
There is also evidence that discontent amongst unemployed people is a major source of social unrest.Singer Bob Dylan wrote “if you ain’t got nothing, you got nothing to lose.” People in such a situation are likely to have little respect for the way society operates. Extremist groups recruit most successfully in areas
of high unemployment. A negligent attitude towards the unemployed is not in society’s interest.
