Understanding Economics

Understanding  Economics  in  the  Real  World  

Frequently  asked  questions  and  answers  by  Economics  Help  

Introduction  

For  anyone  living  in  the  world,  there  is  no  escape  from  economics.  Whether  we  like  it  or  not,  our  lives  are  to  some  extent  influenced  by  bond  markets,  quantitative  easing  and  exchange  rate  markets.  

Most  of  us  have  a  vague  idea  about  economics,  but  there  can  also  appear  several  areas  of  confusion  and  paradox.  Some  things  such  as  exchange  rates  and  bond  market  seem  to  require  a  degree  in  accounting  and  finance  to  understand.  With  gaps  in  our  knowledge,  we  often  end  up  asking  ourselves  questions  like:  

• Why  do  government  encourage  people  to  save  responsibly  and  then  borrow  astronomical  sums  themselves?  

• Why  do  we  have  an  inflation  target,  but  no  target  for  reducing  unemployment?  

• Why  is  it  sometimes  good  to  have  a  fall  in  the  exchange  rate,  and  at  other  times  bad?  

• Why  do  economists  disagree  so  often?  

If  you  are  interested  in  finding  answers  to  these  kinds  of  questions,  this  book  will  hopefully  explain  some  of  the  main  issues  in  economics  and  how  it  affects  our  daily  life.  

One  caveat  worth  mentioning  -­‐  when  starting  to  learn  about  economics  there  can  be  a  confusing  array  of  new  terms  and  ideas.  It  is  hard  to  learn  about  one  topic  (e.g.  government  borrowing)  without  coming  across  related  ideas  on  interest  rates,  and  inflation.  Therefore,  in  the  beginning,  it  is  fine  not  to  understand  everything.    Just  persevere  and  try  to  pick  up  one  thing  at  a  time.  Later,  you  may  look  back  and  (hopefully)  see  how  everything  fits  together.  I  always  tell  my  students  that  the  first  two  years  are  the  worst.  J  

At  the  end  of  this  e-­‐book  there  is  a  list  of  economic  terms  which  might  be  helpful  for  beginners.  

-­‐  Tejvan  Pettinger,  Oxford  2012    

What  do  Economists  actually  do?  

Some  say  economists  make  a  lot  of  money  from  explaining  why  their  economic  forecasts  didn't  come  true.  Whilst  this  does  have  an  element  of  truth,  more  seriously,  economists  try  to  understand  how  the  economy  is  working.  From  observing  what  is  happening,  they  can  offer  suggestions  on  how  to  improve  the  economy.  

For  example,  an  economist  may  try  to  work  out  what  causes  inflation.  With  this  knowledge,  they  may  be  able  to  suggest  what  a  government  needs  to  do  to  keep  inflation  under  control.  

What  is  the  Economy?  

The  economy  refers  to  the  process  of  producing  and  selling  goods  and  services.  The  economy  combines  all  the  individuals  and  firms  buying  and  selling  goods.  When  you  buy  a  snack  in  a  shop  you  are  participating  in  the  total  expenditure  of  the  economy.  If  you  work  as  a  teacher  or  builder  you  are  contributing  to  the  output  of  the  economy.  When  you  receive  wages  from  a  firm,  it  is  part  of  the  national  income  of  the  economy.  

From  an  individual  perspective,  we  have  many  economic  decisions  to  make.  Should  I  do  overtime?  How  should  I  travel  to  work?  Should  I  increase  my  savings  or  spend  more?  

All  these  individual  decisions  contribute  to  the  wider  macro  economy.  For  example,  it  might  seem  good  sense  to  increase  your  personal  saving,  but  if  everyone  increased  his  or  her  level  of  saving  at  the  same  time,  it  could  cause  a  fall  in  consumer  spending  and  lower  aggregate  demand;  this  fall  in  spending  could  cause  lower  economic  growth  and  possibly  a  recession.  

This  is  also  known  as  the  ‘paradox  of  thrift’.  The  paradox  is  that  it  may  be  a  good  idea  for  you  to  personally  save,  but  if  everyone  increased  their  saving  at  the  same  time  it  could  cause  a  problem.  

This  doesn’t  mean  saving  is  ‘bad’.  Most  economists  say  it  would  be  better  if  the  UK  saved  more.  The  problem  occurs  if  we  rapidly  increase  saving  and  reduce  our  spending  when  the  economy  is  weak.  But,  this  will  be  explained  more  later.  

A  Simple  Model  of  an  Economy    

In  a  very  simple  model  of  the  economy,  we  have:  

1. Output.  Firms  produce  goods  and  services.  2. Income.  Wages  /  profit.  Workers  receive  wages  for  producing  goods.  

Firms  make  profit  from  selling  goods.  3. Expenditure.  Workers  use  their  wages  to  purchase  goods.  

From  this  simple  model  we  may  also  add:  

1. Imports  and  Exports.  The  UK  trades  with  other  countries  (e.g.  buying  oil,  selling  financial  services).  This  is  measured  by  the  balance  of  payments.  

2. Government.  The  government  raise  money  from  various  taxes  and  spend  on  various  public  services,  such  as  transport  and  health  care.      

You  could  have  an  economy  without  the  government  -­‐  perhaps  on  a  desert  island  with  a  small  group  of  people  living  in  harmony.  But,  in  developed  society  we  need  a  degree  of  government  intervention  to  regulate  the  economy.  

Different  Schools  of  Economics  

There  are  different  schools  of  economics  which  stress  different  beliefs  and  ideas.  This  is  a  brief  summary  of  the  main  branches  of  economics.  

Classical  Economics  /  Free  Market  Economics  

Classical  economics  stresses  the  role  of  the  free  market  and  are  generally  suspicious  of  government  intervention  in  the  economy.  Free  markets  essentially  mean  the  absence  of  government  intervention,  i.e.  a  free  market  allows  private  firms  and  consumers  to  decide  what  to  produce  and  consume.  

Adam  Smith,  in  his  influential  book  ‘Wealth  of  Nations’  suggested  that  a  free  market  operated  effectively  without  government  intervention.  Adam  Smith  observed  that  if  people  pursue  their  own  ‘selfish  interests’  it  actually  led  to  the  benefit  of  everyone.    For  example,  in  the  pursuit  of  profit,  firms  would  provide  the  goods  that  consumers  wanted  to  buy.  Therefore  in  a  free  market  there  should  be  an  efficient  allocation  of  resources.  This  belief  in  free  markets  formed  the  basis  of  early  or  ‘classical’  economics.      

Classical  economics  believe  that  the  role  of  government  should  be  limited  to  the  protection  of  private  property  and  perhaps  regulating  firms  with  monopoly  power.  But,  essentially,  they  believe  in  little  government  intervention,  low  taxes  and  low  government  spending.  

Laissez-­‐faire  Economics  

Free-­‐market  economics  is  also  referred  to  as  ‘laissez-­‐faire’  economics.  -­‐  The  idea  of  allowing  things  to  occur  without  government  intervention.  This  belief  in  laissez-­‐faire  was  very  strong  in  the  Victorian  period.  It  is  why  the  government  refused  to  get  involved  in  building  of  the  nations  railway  lines.  It  is  why  many  towns  in  the  south  of  England  had  two  train  stations  operated  by  two  competing  separate  company.  In  laissez-­‐faire  economics,  there  is  no  role  for  a  government  welfare  state.  The  Victorians  feared  a  government  safety  net  would  encourage  the  poor  to  become  ‘feckless’  and  lazy.      

Keynesian  Economics  

In  the  1930s,  the  great  depression  seemed  to  show  many  flaws  in  the  classical  model.  Free  markets  were  not  working  efficiently  -­‐  there  was  mass  unemployment  that  persisted  for  a  long  time.  Keynes  argued  in  this  situation  there  was  a  greater  need  for  government  intervention  to  stimulate  aggregate  demand  and  overcome  the  recession.  

Keynes  advocated  government  borrowing  to  finance  spending  on  public  works  and  create  economic  growth.  A  basic  tenant  of  Keynesianism  is  that  the  government  needed  to  take  responsibility  for  managing  demand  and  economic  

growth  –  and  not  leave  it  to  the  market  as  classical  economists  advocated.  Note:  Keynesian  economics  isn’t  a  justification  for  higher  government  spending  per  se.  It  emphasises  the  importance  of  increasing  government  spending  in  a  recession.  

Socialist  /  Marxist  Economics  

Socialist  economics  emphasises  the  inherent  unfairness  of  capitalist  society.  Marxist  theory  suggests  the  means  of  production  should  be  owned  and  managed  by  the  state,  and  the  state  should  run  industries  in  the  public  interest  rather  than  for  profit.    However,  State  Communism  seemed  to  create  a  new  class  of  bureaucrats  and,  due  to  a  lack  of  incentives,  firms  had  a  tendency  to  be  inefficient.  There  was  a  time  in  the  1930s,  when  the  Soviet  Union  made  rapid  economic  growth,  despite  state  control.  But,  by  the  1980s,  Communist  economies  had  fallen  rapidly  behind  similar  economies  in  the  west.  

Monetarist  Economics  

Monetarists  share  many  similar  beliefs  to  ‘classical  economists’.  They  generally  advocate  lower  levels  of  government  intervention.  Monetarists  also  have  particular  views  on  monetary  and  fiscal  policy.  Milton  Friedman,  a  leading  ‘Monetarist’,  argued  there  was  a  strong  link  between  the  money  supply  and  inflation.  Therefore  a  monetarist  would  stress  controlling  the  money  supply  as  a  means  to  controlling  inflation.  Monetarists  are  sceptical  about  fiscal  policy  (e.g.  generally,  they  don’t  believe  higher  government  spending  can  help  the  economy).  They  argue  higher  government  spending  won’t  increase  real  output,  but  just  cause  inflation.    

Monetarism  was  tried  in  the  UK  between  1979-­‐1984.  The  incoming  Conservative  government  pledged  to  reduce  inflation  and  control  the  money  supply.  To  this  end  they  pursued  tight  fiscal  (higher  taxes)  and  tight  monetary  policy  (higher  interest  rates).    They  were  successful  in  reducing  inflation,  but  at  the  cost  of  a  deep  recession  and  high  unemployment.  Monetarism  was  effectively  abandoned  by  1984,  as  the  link  between  inflation  and  the  money  supply  proved  to  be  very  unreliable.  

Austrian  Economics  

Austrian  economics  have  a  disdain  for  government  intervention.  In  this  sense  they  have  similarities  with  classical  economics  in  promoting  free  markets  and  discouraging  government  intervention  in  the  economy.  Austrian  economics  also  argue  that  ‘fiat  money’  money  not  backed  by  gold  tends  to  devalue  due  to  inflation.  For  example,  Austrian  economists  would  not  support  an  expansion  of  the  monetary  base  in  a  recession.  Austrian  economists  would  advocate  going  back  to  a  gold  standard  (all  money  backed  by  actual  gold  reserves).      

The  Great  Debate  

In  economics  there  is  an  on-­‐going  debate  about  the  extent  of  government  intervention  in  the  economy.  On  the  one  hand  ‘free  market’  economists  believe  governments  should  concentrate  on  allowing  capitalism  to  flourish.  Keynesians  argue  the  government  needs  to  be  more  active,  especially  when  the  economy  is  in  recession.    

There  is  also  a  debate  at  the  extent  to  which  the  government  should  intervene  to  deal  with  the  inequalities  created  by  a  free  market.    

This  economic  debate  is  also  mirrored  by  a  political  debate.  Those  on  the  ‘left’  tend  to  favour  more  government  intervention  to  promote  greater  equality.  Those  on  the  ‘right’  feel  it  is  more  important  to  allow  people  to  gain  their  rewards  of  hard  work  (i.e.  inequality)  and  allow  markets  to  operate  freely.  

In  practise,  there  is  no  ‘simple  ideology’  to  explain  different  economic  issues.  Usually,  economic  issues  involve  a  combination  of  different  factors  and  ideas.  I  tend  to  be  wary  when  someone  claims  they  have  a  simple  model  which  explains  everything.    

One  Armed  Economist  To  illustrate  the  reluctance  of  economists  to  commit  to  definite  prescriptions,  in  the  1940s,  the  US  President  H.  Truman  exclaimed    

‘Give  me  a  one-­‐handed  economist’    

He  had  got  so  fed  up  with  economists  always  saying:  

“well,  we  could  do  that,  but  on  the  other  hand….”  

Nevertheless,  when  starting  to  learn  about  economics,  we  do  need  to  isolate  certain  variables  and  understand  basic  theories.  Only  when  we  have  the  basic  idea  behind  theories  can  we  learn  when  they  are  applicable  and  when  we  need  to  consider    -­‐  ‘but,  on  the  other  hand…’  

Key  Economic  Issues  

1. Economic  growth  and  living  standards  2. Recessions  3. Inflation  4. Unemployment  5. Government  Spending  /  Tax  6. Government  Borrowing  7. Balance  of  Payments  8. Interest  Rates  /  Monetary  Policy  9. Banking  System  10. Exchange  Rates  11. Euro  12. Globalisation    13.  Free  Trade  14.  Disagreements  of  Economists  15.  Frequently  Asked  Questions  

1.  Economic  Growth  

Economic  growth  means  there  is  an  increase  in  the  size  of  the  economy.  It  means  more  will  be  produced  and  people  should  be  able  to  consume  more  goods  and  services.  In  theory,  economic  growth  should  lead  to  better  living  standards.    

If  you  compare  living  standards  now  and  100  years  ago,  we  have  a  very  different  level  of  wealth  and  income.  The  average  person  can  consume  much  more.    This  is  due  to  several  decades  of  economic  growth.  

• Economic  Growth  is  measured  by  changes  in  Real  GDP,  which  shows  the  total  value  of  goods  and  services  produced.  

• Real  GDP  means  we  take  into  account  inflation.    An  increase  in  real  GDP  means  there  is  actually  more  goods  produced  and  not  just  more  money  in  the  economy.  

• Typically,  the  UK  economy  grows  on  average  by  2.5%  a  year.  • However,  the  graph  below  shows  economic  growth  can  be  quite  volatile.  

Economic  growth  in  UK  –  showing  deep  recession  of  2008-­‐09.  

Why  is  Economic  Growth  Important?  

Most  governments  target  higher  economic  growth.  Higher  economic  growth  has  various  benefits  for  the  economy.  

1. Higher  wages.  Increased  real  GDP  means  we  can  have  higher  incomes  and  purchase  more  goods  and  services  

2. Helps  reduce  unemployment.  If  there  is  economic  growth,  firms  will  be  expanding  and  taking  on  more  workers,  this  helps  to  reduce  unemployment.  

3. The  Government  receive  more  tax.  If  we  have  economic  growth  and  higher  incomes  then  the  government  will  get  more  tax  revenue  –  even  though  tax  rates  stay  the  same  (e.g.  basic  rate  of  income  tax  of  23%).  This  enables  the  government  to  increase  spending  on  public  services  like  health  care  and  education.  

4. Reduces  the  Government’s  debt  burden.  Most  people  assume  that  government  borrowing  leads  to  higher  tax  rates  in  the  future.  But,  if  there  is  economic  growth,  then  we  can  use  the  higher  tax  receipts  to  reduce  the  ratio  of  debt  to  GDP,  without  increasing  tax  rates.  

5. Improved  public  services.  With  higher  national  income,  we  should  in  theory  be  able  to  spend  more  on  welfare  policies  which  help  to  reduce  poverty  and  provide  better  living  standards.  

Are  there  any  problems  With  Economic  Growth?  

• Inflation.  If  economic  growth  is  too  fast,  demand  for  goods  may  be  increasing  faster  than  UK  firms  can  produce  them.  Therefore,  firms  respond  by  putting  up  prices,  which  causes  inflation.    

• Boom  and  Bust  Cycle.  If  economic  growth  is  too  fast  it  tends  to  be  unsustainable.  This  can  lead  to  a  boom  and  bust  cycle.  This  occurs  when  growth  is  very  high,  but  is  followed  by  a  slump  (negative  economic  growth).  In  the  1980s,  the  UK  experienced  a  boom,  with  rapid  economic  growth  of  over  5%  a  year.  However,  this  rate  of  growth  proved  unsustainable,  leading  to  inflation  and  later  the  recession  of  1991-­‐92.  

• Environmental  Costs.  Higher  economic  growth  usually  leads  to  greater  use  of  raw  materials  and  pollution.  Therefore  although  we  may  have  higher  output,  living  standards  may  not  actually  increase.    

Link  Between  Inflation  and  Economic  Growth  

In  theory,  higher  economic  growth  causes  higher  inflation.    

• For  example,  during  a  period  of  strong  economic  growth  in  the  1980s,  we  can  see  a  rise  in  the  rate  of  inflation.  Attempts  to  reduce  this  high  inflation  led  to  the  recession  of  1991.      

Link  Between  Economic  Growth  and  Inflation  in  US  

• This  shows  there  is  a  rough  trade  off  between  inflation  and  unemployment.  

• For  example,  in  1979,  inflation  falls  from  14%  to  2%,  but  during  this  period,  unemployment  rises  from  7%  to  11%.  

• At  the  start  of  2008,  inflation  drops  sharply  (a  rare  period  of  deflation  in  2009)  and  unemployment  again  rises.  

• This  shows  there  is  often  a  trade  off  between  inflation  and  unemployment.    

Q.  Why  Does  it  Feel  Like  Prices  Go  up  in  a  Recession?  

• Typically,  lower  economic  growth  leads  to  lower  inflation.  However,  it  is  also  possible  for  inflation  to  increase  at  the  same  time  as  negative  economic  growth.  

• For  example,  a  rapid  rise  in  oil  prices  (e.g.  1974,  2008,  2011)  leads  to  a  squeeze  on  living  standards.  Prices  rise  quicker  than  nominal  wages,  leading  to  lower  consumers  spending  and  lower  economic  growth,  but  also  higher  prices  (termed  cost-­‐push  inflation.)    

Happiness  Index  

Some  critics  of  economics  argue  that  too  much  emphasis  is  placed  on  increasing  income  and  wealth.  They  argue  this  focus  on  economic  growth  ignores  more  important  factors  that  influence  living  standards,  such  as  the  environment,  education  and  health  care.  

You  could  ask  -­‐  are  we  happier  than  30  years  ago?  

GDP  is  certainly  much  higher  than  30  years  ago.  But:  

• There  is  more  crime  • There  is  greater  congestion  on  our  roads.  • There  is  a  shortage  of  affordable  housing.  • Arguably  stress  and  dissatisfaction  levels  are  just  as  high.  • The  environment  is  a  cause  for  concern  with  issues  such  as  depletion  of  

rain  forests  and  global  warming.  • People  are  working  longer  hours,  leaving  less  time  for  leisure.  • There  has  been  a  growth  in  obesity  and  cancer  levels.    

This  shows  the  limitation  of  economic  statistics.  Economic  growth  has  potential  benefits,  but  there  is  much  more  to  life  than  higher  real  GDP.  To  improve  living  standards,  we  need  to  consider  much  more  than  simple  statistics  on  wealth  and  income.  

If  you  are  old  enough,  you  might  remember  the  BBC  Sitcom  –  The  Good  Life.  A  couple  in  Surbiton  gave  up  their  jobs  in  the  city  to  be  self-­‐sufficient  in  their  Surbiton  back  garden.  From  an  economic  point  of  view,  their  income  fell  drastically,  but  this  ‘good  life’  could  give  more  happiness  than  working  all  day  in  a  boring  9-­‐5  job.  

However,  although  we  may  like  to  complain  about  modern  life,  it  is  hard  to  argue  we  would  be  better  off  over  120  years  ago  with  the  Victorian  slums.  Economic  growth  has  enabled  a  significant  increase  in  living  standards.  Generally  people  are  able  to  avoid  absolute  poverty  (not  enough  money  for  basic  necessities).  This  kind  of  poverty  did  occur  in  the  nineteenth  century,  but  has  largely  been  abolished  thanks  to  prolonged  economic  growth,  which  has  helped  increase  living  standards.  

In  the  post  war  period,  we  have  also  been  able  to  afford  a  national  health  care  service  and  universal  welfare  benefits,  which  has  helped  to  reduce  inequality.  

Economic  growth  has  benefits,  but  also  it  has  limitations.  It  is  not  a  cure  for  all  ills.  Economics  growth  definitely  makes  it  easier  to  tackle  certain  issues,  but  can  also  create  its  own  problems.  

What  Affects  the  Rate  of  Economic  Growth?  

Economic  growth  requires  two  things:  

1. Increased  demand  (consumer  spending,  government  spending,  export  demand,  and  investment  spending)  

2. Increased  supply  /  increased  productive  capacity.  

• If  we  have  higher  demand,  but  firms  can’t  increase  supply,  then  consumers  will  be  frustrated  and  there  will  be  inflation  rather  than  economic  growth.  

• Similarly,  it  is  no  good  producing  more  goods  if  the  demand  isn’t  there.  There  will  just  be  unsold  goods  and  spare  capacity.  

Demand  in  the  economy  can  increase  if:  

1. Consumers  have  higher  wages  and  want  to  spend  it.  2. Demand  for  exports  from  abroad,  e.g.  countries  like  China,  Japan  and  

Germany  rely  on  selling  exports.  3. Lower  interest  rates.  Lower  interest  rates  increase  household  disposable  

income  (e.g.  lower  mortgage  interest  payments)  encouraging  people  to  spend.  

4. Confidence.  If  people  are  confident  about  the  future  they  are  more  likely  to  borrow  and  spend  rather  than  save.  

5. Rising  wealth.  Rising  house  prices  gives  householders  greater  confidence  to  spend.  Rising  house  prices  also  enable  firms  to  re-­‐mortgage  and  gain  equity  withdrawal.  

6. Firms  invest  creating  more  employment  and  demand  for  capital.  7. Increased  government  spending,  e.g.  higher  wages  for  public  sector  

workers.  

Aggregate  Supply  can  increase  if:  

1. Firms  expand  production,  e.g.  invest  in  building  new  factories  2. Workers  become  more  productive  (higher  output  per  worker).  For  

example,  if  workers  learn  new  skills  or  become  more  motivated  to  work  hard.  

3. Better  communication  and  transport  links.  4. Growth  in  population,  e.g.  immigration,  especially  if  new  workers  are  

skilled  in  areas  of  job  shortages.  5. Improvements  in  technology,  e.g.  Internet  and  microcomputers  make  the  

economy  more  productive.  

Question:  Why  has  China  been  able  to  manage  economic  growth  of  nearly  10%  a  year  since  the  1980s?  

For  nearly  three  decades,  the  Chinese  economy  has  been  able  to  expand  at  a  breakneck  pace,  catching  up  with  developed  economies  in  the  West.  China’s  growth  has  averaged  close  to  10%;  this  is  much  higher  than  the  UK’s  growth  rate,  which  has  averaged  2.5%  in  the  same  period.  

Reasons  for  the  rapid  rate  of  economic  growth  in  China  include:  

1. Potential  efficiency  gains  from  privatising  state  owned  industries.  For  many  years,  China  was  a  centrally  planned  Communist  economy.  Many  state  owned  industries  were  highly  inefficient  (because  workers  had  a  lack  of  incentives  and  there  was  overstaffing).  Many  of  these  industries  have  been  privatised  and  this  has  enabled  leaps  in  productivity  and  efficiency  (e.g.  sacking  surplus  workers)  

2. Shift  from  Agricultural  sector  to  manufacturing.  China  had  a  large  proportion  of  workers  in  agriculture.  Small,  inefficient  farms  meant  that  farm  workers  contributed  very  little  to  output.  The  growth  of  the  manufacturing  sector  has  enabled  much  greater  output  than  in  the  agricultural  sector.  

3. Low  Wage  Costs.  China  has  millions  of  workers  willing  to  move  to  the  manufacturing  sector  at  relatively  low  global  wages.  This  has  meant  that,  despite  the  growth  of  the  export  sector,  manufacturing  wages  have  remained  low,  giving  China  a  continued  competitive  advantage.  

4. Globalisation  and  Comparative  Advantage  in  Exports.  China’s  growth  has  been  largely  based  on  exports.  The  process  of  globalisation  has  helped  create  a  large  global  market  for  China’s  exports.  

5. Weak  Chinese  Currency.  A  factor  that  has  contributed  to  China’s  growth  is  the  relative  weakness  of  the  Chinese  currency  –  the  Yuan.  China  has  deliberately  kept  the  currency  undervalued  to  make  its  exports  more  competitive.  This  isn’t  the  main  reason  for  economic  growth  in  China,  but  it  has  helped  provide  an  extra  boost  to  export  demand.  

At  this  stage  in  China’s  economic  development,  there  is  more  potential  for  rapid  growth.  It  would  be  much  harder  for  the  UK  to  experience  such  rapid  growth  in  productivity  and  productive  capacity,  because  the  economy  is  already  more  developed  and  there  isn’t  the  same  scope  for  efficiency  gains.  

Global  Inequality  

There  is  huge  inequality  between  nations,  which  can  be  illustrated  by  Real  GDP  per  capita  statistics.  

• Real  GDP  per  Capita.  –  This  means  the  average  income  per  person  in  the  country.    

How  Does  the  UK  compare  to  other  countries?  

According  to  the  IMF  (2010)  the  UK  is  ranked  22nd  in  terms  of  GDP  per  Capita.  

Selected  countries:  

• Luxembourg         $108,832  (1st)  • United  States         $47,284  (9th)  • France         $41,019  (18th)  • United  Kingdom       $36,120  (22nd)  • Ethiopia         $350  (178th)  • Congo,  Democratic  Republic  $186  (182th)  

This  shows  a  huge  disparity  in  average  incomes.  A  person  in  Luxemburg  is  likely  to  have  an  income  nearly  50  times  greater  than  the  Congo.  

Reasons  for  Inequality  

To  some  extent,  statistics  don’t  tell  the  full  story.  

• There  is  a  cheaper  cost  of  living  in  poor  countries.  It  will  be  much  cheaper  to  rent  accommodation  in  Congo  than  a  developed  country.  Therefore  they  are  not  strictly  comparable.  An  annual  income  of  $350  wouldn’t  last  a  week  in  Luxembourg,  but  goes  much  further  in  the  Congo.  

• Subsistence  Living.  In  very  poor  developing  economies,  people  may  live  as  subsistence  farmers.  Growing  their  own  food,  they  may  receive  no  cash  payments.  Therefore,  according  to  GDP  statistics  they  have  zero  income,  but  a  subsistence  farmer  could  have  a  reasonable  living  standard  if  food  is  plentiful.  

These  factors  reduce  effective  inequality,  to  some  degree,  but,  despite  this,  there  is  also  still  a  vast  gulf  in  living  standards  between  different  parts  of  the  world.  This  has  a  profound  impact  on  living  standards  across  the  world.  Countries  with  higher  real  GDP  per  capita  tend  to  have  greater  life  expectancy,  higher  rates  of  literacy  and  provision  of  social  services.  

Reasons  for  Gulf  in  Living  Standards  across  the  Globe  

• Different  levels  of  economic  development.  For  example,  the  UK  economy  went  through  process  of  industrialisation  in  the  nineteenth  century;  some  developing  economies  are  still  largely  agrarian.    

• Development  held  back  by  corruption  /  civil  war.  Often  war,  corruption  and  political  uncertainty  can  be  a  key  factor  in  discouraging  economic  development.  

• Regional  Effect.  Countries  in  Europe  tend  to  benefit  from  the  strength  of  other  European  economies.  Countries  in  Sub-­‐Saharan  Africa  are  constrained  by  low  levels  of  economic  development  in  neighbouring  countries.  

Why  are  The  Poorest  Countries  often  the  Richest  in  terms  of  Raw  Commodities?  

It  is  a  paradox  that  countries  like  Germany  and  Japan  are  relatively  poor  in  terms  of  raw  materials  (Japan  has  to  import  most  of  its  raw  materials).  Yet,  some  African  countries  with  an  abundance  of  diamonds,  oil  and  gold  are  among  the  poorest.  

• Owning  raw  materials  is  not  a  guarantee  of  wealth.  Foreign  multinationals  or  a  small  number  of  local  owners  can  siphon  off  profits  from  gold  and  diamonds.  In  this  case,  most  workers  may  see  little  benefits  from  the  raw  materials.  

• It  also  shows  how  international  trade  enables  countries  to  benefit  from  adding  value  to  raw  materials  and  selling  at  a  profit.    Japan  and  Germany  have  excelled  at  adding  value  to  manufactured  goods.  

• Substantial  raw  material  reserves  can  help  boost  living  standards,  but  much  more  is  needed,  such  as  infrastructure  and  a  developed  economy.    

• It  is  also  important  how  equitably  resources  are  distributed  throughout  the  economy.  

2.  Recession  

A  recession  means  we  have  negative  economic  growth.  It  means  the  economy  is  becoming  smaller  in  size.  (The  technical  definition  of  a  recession  is  a  period  of  negative  economic  growth  for  two  consecutive  quarters  (6  months).    During  a  recession:  

• Consumers  will  be  buying  fewer  goods  –  especially  luxury  goods  like  sports  cars.  

• Firms  will  cut  back  on  production.  Some  firms  may  go  out  of  business  because  they  are  not  selling  enough.  

• Unemployment  will  rise.  As  firms  cut  back  on  production  they  need  less  workers.  

• Low  inflation.  Firms  have  unsold  goods  so  typically  cut  prices  to  try  and  sell  more.  In  some  cases,  this  may  lead  to  deflation.  

• Government  borrowing  increases.  Governments  will  receive  lower  income  tax  and  lower  VAT  receipts.  However,  they  have  to  spend  more  on  unemployment  benefits.  Therefore  in  a  recession,  government  borrowing  automatically  tends  to  rise.  

• Saving  increases.  In  a  recession,  people  are  nervous  about  spending  and  borrowing;  instead  people  tend  to  increase  their  level  of  savings.  

• Exchange  rate  is  likely  to  become  weaker  as  interest  rates  in  the  country  will  be  low.  

What  Causes  Recessions?  

A  recession  can  be  caused  by  a  variety  of  factors  that  lead  to  lower  spending  and  demand  in  the  economy.  

1.  Higher  interest  Rates.  In  1991  interest  rates  were  increased  to  15%.  This  made  mortgages  very  expensive,  leaving  households  with  little  income  left  over  to  spend.  This  caused  a  fall  in  consumer  spending  and  negative  economic  growth.  

2.  Appreciation  in  the  Exchange  Rate.  In  1979-­‐80,  the  UK  experienced  a  rapid  rise  in  the  value  of  the  Pound.  This  made  UK  exports  uncompetitive,  leading  to  a  sharp  fall  in  demand  for  exports  and  a  decline  in  the  manufacturing  sector  (manufacturing  output  fell  30%  during  this  period).  The  strong  exchange  rate  also  occurred  during  a  time  of  higher  interest  rates  and  policies  to  reduce  inflation.  

3.  Credit  Crunch.  In  2007,  banks  lost  a  lot  of  money  and  struggled  to  maintain  their  liquidity;  therefore,  they  had  to  cut  back  on  lending  to  firms  and  consumers.  It  became  very  difficult  to  get  a  loan  or  mortgage  from  a  bank;  this  led  to  a  fall  in  spending  and  business  investment.  

4.  Confidence.  If  consumers  and  firms  become  worried  about  the  future,  they  will  spend  less  and  save  more  –  causing  a  fall  in  overall  demand.  Therefore,  if  

people  fear  a  recession,  it  can  become  self-­‐fulfilling.  (There  is  a  saying  that  you  can  ‘talk  yourself  into  a  recession’)  

There  can  also  be  a  bandwagon  effect.  When  the  recession  starts  and  unemployment  rises,  this  causes  a  fall  in  income  for  the  unemployed;  this  causes  a  bigger  fall  in  confidence  and  even  bigger  fall  in  output.  

• For  example,  the  Wall  Street  Crash  of  1929  caused  a  loss  of  confidence  in  the  stock  market  and  financial  markets.  This  was  a  significant  factor  (though  not  the  only  one)  that  caused  the  Great  Depression  of  the  1930s  

• After  9/11  there  was  a  fall  in  confidence  in  the  US  economy.  The  government  and  Federal  Reserve  responded  very  quickly  to  try  and  maintain  economic  growth.  

• Falling  house  prices  tend  to  reduce  confidence  too.  

5.  Rising  Oil  Prices.  Rapidly  rising  oil  prices  could  cause  a  recession.  In  the  1970s,  the  oil  price  almost  tripled,  this  was  a  real  shock  to  western  economies  that  were  reliant  on  cheap  oil.  The  rise  in  oil  prices  reduced  disposable  income  and  led  to  lower  spending  and  a  short-­‐lived  recession  of  1974.  

6.  Global  Recession.  In  the  global  economy,  it  is  hard  to  remain  unaffected  by  the  situation  in  other  countries.  If  other  countries  enter  recession,  there  will  be  a  fall  in  demand  for  UK  exports;  there  will  also  be  a  fall  in  confidence  leading  to  lower  growth.  Also  the  banking  system  is  very  global.  If  banks  lose  money  in  America,  it  tends  to  reduce  lending  by  UK  banks  

7.  Falling  Asset  Prices.  If  there  is  a  rapid  fall  in  house  prices,  this  tends  to  reduce  consumer  spending  as  householders  see  a  decline  in  wealth.  Falling  asset  prices  also  lead  to  higher  bank  losses  making  banks  reduce  their  lending.  Falling  asset  prices  were  closely  linked  with  the  credit  crunch  in  2007-­‐09.  Falling  asset  prices  can  be  prolonged  and  it  can  be  harder  to  recover  from  this  kind  of  recession.  

Paradox  of  Thrift  

'Paradox  of  thrift;  is  a  concept  that  if  individuals  decide  to  increase  their  private  saving  rates,  it  can  lead  to  a  fall  in  general  consumption  and  lower  output.  

Therefore,  although  it  might  make  sense  for  an  individual  to  save  more,  a  rapid  rise  in  national  private  savings  can  harm  economic  activity  and  be  damaging  to  the  overall  economy.  

In  a  recession,  we  often  see  this  'paradox  of  thrift'.  Faced  with  prospect  of  recession  and  unemployment,  people  take  the  reasonable  step  to  increase  their  personal  saving  and  cut  back  on  spending.  However,  this  fall  in  consumer  spending  leads  to  a  decrease  in  aggregate  demand  and  therefore  lower  economic  growth.  

Paradox  of  Thrift  in  1930s  

In  the  great  depression  of  the  1930s,  GDP  fell;  unemployment  rose  and  the  UK  experienced  a  long  period  of  deflation.  In  response  to  this  disastrous  economic  situation,  mainstream  economists  were  at  a  loss  as  how  to  respond.  Such  a  lengthy  period  of  disequilibrium  didn’t  sit  well  with  Classical  theory,  which  expected  markets  to  operate  smoothly  and  efficiently.  

One  policy  the  National  government  did  approve  was  the  cutting  of  unemployment  benefits.  The  rationale  was  that  in  times  of  a  depression  the  government  should  set  an  example  by  reducing  its  debt.  This  example  actually  inspired  members  of  the  public  to  send  in  their  savings  in  the  hope  that  it  would  help  the  economy.  

By  reducing  benefits  they  further  reduced  consumer  spending  and  overall  demand.  This  made  areas  of  high  unemployment  even  more  impoverished.  When  people  saved  rather  than  spent  their  money  it  just  made  the  recession  worse.  

J.M.  Keynes  argued  that  this  'paradox  of  thrift'  was  pushing  the  economy  into  a  prolonged  recession.  He  argued  that  in  response  to  higher  private  saving,  the  government  should  borrow  from  the  private  sector  and  inject  money  into  the  economy.  

This  government  borrowing  wouldn't  cause  crowding  out  because  the  private  sector  were  not  investing,  but  just  saving.  

In  the  UK  and  US,  Keynes  was  largely  ignored  until  the  outbreak  of  war.  For  much  of  the  1930s,  the  UK  economy  experienced  high  levels  of  unemployment.  

Can  Governments  Prevent  Recessions?  

In  theory,  governments  can  prevent  recessions.  In  practise  it  can  be  difficult.  

1. Demand  Side  Policies.  If  the  government  expect  a  recession  due  to  falling  private  sector  demand.  They  can  pursue  expansionary  fiscal  policy  (higher  government  spending  /  lower  tax).    This  expansionary  fiscal  policy  requires  higher  government  borrowing.  But,  the  governments  borrowing  should  help  to  offset  the  rise  in  private  sector  saving.    These  injections  of  spending  could  kick-­‐start  the  economy  and  create  demand  and  jobs.  If  the  government  does  nothing,  the  recession  may  persist  for  a  long  time.  However,  in  a  recession,  it  may  be  difficult  for  the  government  to  borrow  more  (e.g.  Eurozone  economies  faced  great  difficulties  with  borrowing  more  in  the  2008-­‐11  recession.)  

2. Prevent  Boom  and  Bust  Cycles.  With  the  help  of  the  Central  Bank,  the  government  can  try  and  prevent  boom  and  bust  economic  cycles.  This  is  why  they  target  low  inflation  and  economic  growth  that  is  sustainable.  If  inflation  remains  low  and  growth  sustainable,  there  doesn’t  have  to  be  a  rapid  increase  in  interest  rates,  which  can  cause  a  recession.  

3. Prevent  Asset  Bubbles  They  can  avoid  boom  and  bust  in  lending  and  asset  markets.  In  theory,  the  government  could  introduce  regulation  to  

prevent  property  bubbles  and  a  boom  in  bank  lending  which  becomes  unstable.  In  practise  this  is  easier  said  than  done.  Governments  and  Central  Banks  may  not  be  able  to  spot  asset  bubbles  (or  they  ignore  the  evidence).  Also,  some  argue  it  is  hard  to  regulate  bank  lending  because  they  can  find  ways  around  it.  

4. Bailout  Banks.  If  banks  go  bust,  it  can  destroy  confidence  in  the  financial  market  and  lead  to  a  decline  in  the  money  supply.  In  1932,  over  500  US  banks  went  bankrupt;  this  made  the  Great  Depression  worse.  Therefore  bailing  out  banks  can  be  in  the  public  interest  because  it  prevents  a  collapse  in  confidence  in  the  financial  sector.  However,  there  is  a  real  problem  that  it  can  encourage  banks  to  take  risky  behaviour  because  they  know  the  government  will  have  to  bail  them  out.        

5. Central  Bank  Intervention.  To  help  prevent  recession,  a  Central  Bank  could  cut  interest  rates,  and  if  necessary  increase  the  money  supply  through  quantitative  easing.    Lower  interest  rates  give  borrowers  more  disposable  income  and  so  encourage  spending  in  the  economy.      

Real  Business  Cycle  

Some  economists  (Real  Business  Cycle)  argue  the  government  can’t  prevent  recessions  and  they  should  just  allow  them  to  run  their  course.  They  argue  government  intervention  often  just  makes  the  situation  worse.  The  real  business  cycle  theory  argues  that  recessions  are  caused  by  technological  changes  and  supply  side  factors,  therefore  demand  plays  little  role.  Therefore,  according  to  the  real  business  cycle  theory  there  is  inevitability  about  recessions.  Some  economists  even  go  as  far  to  say  recessions  are  beneficial.  The  argument  is  that  in  a  recession,  inefficient  firms  go  out  of  business,  and  there  are  greater  incentives  for  firms  to  cut  costs  and  be  more  efficient.  Some  famous  firms  like  General  Motors  and  Disney  started  during  a  deep  recession.  

However,  other  economists  argue  this  ignores  the  strong  empirical  evidence  showing  that  recessions  are  caused  by  a  drop  in  private  sector  spending,  and  that  recessions  can  be  avoided.  

Also,  it  is  very  controversial  to  argue  recessions  are  ‘beneficial’.  In  a  recession  there  is  often  long-­‐term  economic  damage,  such  as:  

• Rise  in  long-­‐term  unemployment  (unemployed  find  it  difficult  to  get  back  into  work)  

• Some  good,  efficient  firms  may  go  out  of  business  just  because  of  a  temporary  lack  of  demand.  

• Investment  will  fall  sharply  in  a  recession,  causing  lower  productive  capacity  in  the  future.  

3.  Unemployment  

Unemployment  occurs  when  a  worker  who  is  able  and  willing  to  work,  is  unable  to  find  a  job.  

Prolonged  periods  of  unemployment  can  be  the  most  stressful  experience  for  a  person.  Yet  across  the  European  Union,  unemployment  rates  have  been  persistently  high,  averaging  close  to  10%  

For  example,  in  2011,  Spain  had  an  unemployment  rate  of  21%;  amongst  young  workers  it  was  as  high  as  45%.    

What  Causes  Unemployment?  

1.  Recession.  The  biggest  cause  of  unemployment  is  due  to  the  state  of  the  economy.  If  output  falls  and  we  enter  a  recession,  firms  will  lay  off  workers  or  firms  will  go  bankrupt  completely.  Therefore  demand  for  workers  falls.  

The  above  diagram  shows  the  link  between  economic  growth  and  unemployment.  When  the  economy  contracts,  unemployment  rises.  The  worst  period  for  unemployment  in  the  UK  was  in  the  1930s  during  the  Great  Depression.  In  this  period  unemployment  reaching  12%  +.  In  some  industrial  areas  it  was  as  high  as  40%.  

But  negative  economic  growth  isn’t  the  only  cause  of  unemployment.  Even  during  times  of  strong  economic  growth,  we  can  still  have  unemployment.  What  causes  unemployment  in  these  situations?  

1. Unskilled  Workers.  Often  there  are  job  vacancies,  but  the  unemployed  may  lack  the  skills  and  qualifications  to  take  a  job.  An  unemployed  coal  miner  may  like  to  work  as  a  nurse  or  computer  technician,  but  he  doesn’t  have  any  relevant  skills  to  accept  the  job.  

2. Voluntary  Unemployment.  The  argument  is  that  if  unemployment  benefits  are  generous,  then  people  may  lack  the  incentive  to  take  a  job  at  a  low  wage  rate.  Often  if  people  get  a  job  they  have  to  pay  higher  taxes  and  lose  several  benefits  such  as  unemployment  benefit  and  housing  benefit,  therefore  there  may  be  little  financial  incentive  to  take  a  job.  It  is  worth  pointing  out  that  in  the  UK  the  gap  between  unemployment  benefits  and  wages  has  grown  in  recent  years.  Voluntary  unemployment  is  often  a  controversial  concept.  

3. Wages  Too  High.  Arguably  trades  unions  and  minimum  wages  can  make  labour  too  expensive.  A  hairdresser  may  complain  that  they  could  employ  workers  at  £4  an  hour,  but  the  minimum  wage  of  £5.89  is  too  high.  Therefore  minimum  wages  and  trades  unions  can  cause  unemployment.  However,  there  have  been  periods  of  time  when  increasing  the  minimum  wage  also  leads  to  lower  unemployment.  (1997-­‐2007)    

4. Geographical  Unemployment.  Another  feature  of  unemployment  is  that  it  is  highly  localised.  There  may  be  many  unfilled  vacancies  in  Central  London,  but  in  the  North  East,  unemployment  may  be  very  high.  In  theory  an  unemployed  worker  could  move  south,  but  in  practise  it  may  be  difficult  to  get  accommodation  in  Central  London  and  find  a  new  school  for  their  children.  

5. Takes  Time  To  Find  Work.  Not  all  unemployment  is  long  term;  often  people  are  unemployed  for  a  short  period  -­‐  in  between  jobs.  This  is  known  as  frictional  unemployment  

6. Tight  Regulation.  It  is  argued  that  in  the  EU,  there  are  generous  laws  and  protection  for  workers.  For  example,  it  is  difficult  to  fire  workers  and  there  are  restrictive  practises  like  maximum  working  weeks  and  statutory  pay.  This  is  good  for  workers  with  jobs,  but  the  costs  involved  in  employing  labour  arguably  deter  firms  from  investing  and  hiring  workers  in  the  first  place.  

Question:  Does  Labour  Saving  Technology  cause  Unemployment?  

Ever  since  the  Luddites  went  around  smashing  machines  in  Nineteenth  Century  Britain,  there  has  been  a  strong  fear  that  labour  saving  technology  can  cause  unemployment.  To  some  extent  it  is  true.  If  a  firm  finds  a  machine  that  can  do  the  job  of  10  workers,  then  they  may  be  able  to  get  rid  of  these  surplus  workers  causing  some  temporary  unemployment.  If  these  workers  lack  skills  and  geographical  mobility,  they  may  find  it  difficult  to  find  new  unemployment.  

However,  labour  saving  technology  tends  to  create  as  much  employment  as  unemployment.  

• Firstly,  there  will  be  new  jobs  created  in  making  the  machine.  

• Secondly,  the  labour  saving  technology  helps  reduce  costs  and  prices  of  goods.  Therefore,  overall  consumers  have  more  disposable  income  to  spend  on  other  goods  and  services.  Therefore  other  industries  in  the  economy  tend  to  benefit  from  higher  growth  leading  to  more  job  creation.  

200  years  ago,  90%  of  the  British  workforce  were  working  in  agriculture.  However,  over  time,  new  machines  meant  that  farms  needed  fewer  workers  and  so  people  lost  jobs  on  the  farm.  But,  as  the  economy  devoted  fewer  resources  to  agriculture,  new  jobs  in  manufacturing  were  created.  

As  manufacturing  became  more  efficient,  a  smaller  workforce  was  needed.  This  enabled  a  growth  in  the  service  sector.  –  Jobs  which  can’t  be  done  by  machines  like  doctors,  teaching  and  waiters.  

Technological  change  can  cause  temporary  unemployment,  especially  if  the  change  is  rapid.  It  can  be  a  problem  if  it  is  concentrated  in  a  certain  regions  (e.g.  old  coal  mines).  However,  technological  change  has  enabled  a  different  economy  and  workers  are  able  to  do  less  manual  labour  and  more  service  sector  based  jobs.      

It  makes  no  sense  to  stop  technological  change  to  protect  jobs,  however  it  may  make  a  lot  of  sense  to  help  the  unemployed  develop  new  skills  to  find  new  jobs  in  new  industries.  

How  Can  A  Government  Reduce  Unemployment?  

1. Promote  economic  growth.  In  a  recession,  the  government  and  central  bank  will  need  to  try  and  increase  demand.  This  may  require  government  borrowing.  In  the  great  depression,  Keynes  advocated  an  expansion  in  government  spending  to  try  and  stimulate  economic  growth  and  create  jobs.  

2. Labour  Market  Flexibility.  A  popular  buzzword  among  free  market  economists.  Labour  market  flexibility  means  reducing  levels  of  regulation  and  the  cost  of  hiring  workers.  The  hope  is  that  less  regulation  encourages  firms  to  employ  more  workers  in  the  first  place.  

3. Retrain  Workers.  Workers  who  have  been  unemployed  for  a  long  time,  may  need  to  learn  new  skills  and  be  given  more  motivation  to  keep  looking  for  a  job.  

4. Lower  Benefits.  It  is  argued  reducing  unemployment  benefits  increases  the  incentive  for  the  unemployed  to  get  a  job.  However,  in  the  UK  benefits  are  already  quite  low  compared  to  wages.    

Q.  Why  do  we  have  an  inflation  target  (2%)  but  no  unemployment  target?  

It  often  seems  Central  Banks  are  concerned  about  keeping  inflation  low,  but  not  so  concerned  about  reducing  unemployment.  

The  argument  is  that  low  and  stable  inflation  provides  the  best  framework  for  sustainable  economic  growth.  This  low  inflation  and  economic  growth  will  help  job  creation  in  the  long  term.    

If  you  target  low  unemployment,  it  may  cause  a  boom,  which  temporarily  reduces  unemployment,  but  also  causes  inflation  and  the  economic  growth  will  be  unsustainable.  Therefore  it  is  better  to  target  low  inflation  and  gradually  reduce  unemployment.  

Also,  if  unemployment  is  structural  (lack  of  skills),  the  solution  is  not  to  increase  demand  (lower  interest  rates)  but  supply  side  polices  (e.g.  education  and  training)  and  these  are  long-­‐term  solutions.  

However,  you  could  argue  Central  Banks  do  worry  too  much  about  inflation  and  don’t  give  enough  importance  to  reducing  unemployment.  For  example,  a  rise  in  cost-­‐push  inflation  is  usually  temporary.  To  stick  to  an  inflation  target,  when  there  is  an  oil  price  shock  may  cause  a  recession  and  higher  unemployment.  

Some  economists  argue  for  a  higher  inflation  target  to  give  Central  Banks  more  room  for  manoeuvre  to  achieve  full  employment.    

4.  Inflation  

• Inflation  basically  means  prices  in  the  economy  are  increasing.    • The  inflation  rate  measures  the  annual  %  increase  in  prices.  

Inflation  is  something  we  can  all  relate  to  as  usually  we  see  our  cost  of  living  increasing  each  year.  

Graph  showing  different  rates  of  inflation  in  UK  

My  grandma  would  often  exclaim  how  expensive  things  were  ‘these  days’.  In  ‘her  day’,  you  could  get  a  loaf  of  bread,  pint  of  beer,  train  ride  home  and  still  have  change  from  sixpence.    Now,  to  buy  these  three  goods,  you  wouldn’t  get  much  change  from  a  £10  note.  This  is  an  example  of  how  inflation  increases  prices  over  a  long  period  of  time.  

Inflation  reduces  the  value  of  money.  If  prices  go  up,  it  means  a  £10  note  buys  less  in  2011  than  it  does  in  1940.  Therefore  inflation  will  reduce  the  value  of  money.  This  is  why  in  a  period  of  high  inflation,  it  isn’t  good  to  keep  your  cash  under  your  mattress.  –  the  money  will  soon  become  worthless.  

Q.  Is  Inflation  a  hidden  tax  on  the  middle  classes?  

Inflation  can  definitely  erode  the  value  of  savings.  If  you  have  cash  holdings,  then  inflation  will  reduce  its  value.  

Also,  people  may  buy  government  bonds,  but  inflation  will  reduce  the  value  of  these  bonds,  making  it  easier  for  the  government  to  pay  back  its  debt.  It  will  mean  that  savers  who  buy  government  bonds  lose  the  value  of  their  savings.  

Real  Interest  Rates  

A  key  factor  is  -­‐  what  is  the  interest  rate?  

• If  inflation  is  7%  but  interest  rates  9%,  then  savers  won’t  be  losing  money  if  they  save  in  a  bank.  

• Although  inflation  reduces  the  value  of  money,  the  higher  interest  rates  offsets  the  effects  of  inflation.  

If  markets  fear  a  government  will  ‘inflate  away  its  debt’  then  markets  will  demand  a  higher  interest  rate  on  government  bonds  to  compensate  for  the  risk  of  inflation  reducing  value  of  bonds.  

In  the  post  war  period,  real  interest  rates  were  generally  positive.  This  meant  that  savers  were  not  adversely  affected  by  inflation.  (Unless  they  just  kept  cash  under  their  mattress)  

Inflation  is  a  real  problem,  when  the  inflation  rate  is  higher  than  any  saving  interest  rate.  

Deflation  

In  a  few  occasions  in  the  twentieth  century,  the  UK  has  had  a  negative  inflation  rate.  This  means  prices  were  actually  falling.  This  has  been  very  rare  post  1945.  However,  it  did  occur  during  the  1920s  and  great  depression  of  the  1930s.  Falling  prices  are  known  as  deflation.  

CPI  –  Consumer  Price  Index  

Every  month  we  get  a  new  official  inflation  figure.  For  example,  CPI  =  4.5%.  This  means  the  average  price  of  goods  and  services  increased  by  4.5%  in  the  past  12  months.  

RPI  –  Retail  Price  Index.  

The  RPI  is  similar  to  CPI,  however  it  includes  mortgage  interest  payments.  Therefore,  if  MPC  increased  interest  rates,  the  RPI  would  increase  at  a  higher  rate  than  CPI.  There  are  a  few  other  minor  differences  between  RPI  and  CPI.  RPI  tends  to  be  higher  than  CPI.  

How  is  Inflation  Measured?  

1. Give  a  weighting  to  goods  (how  significant  it  is)  2. Measure  price  changes  of  most  commonly  bought  goods  every  month.  3. Multiply  price  change  *  weighting  of  good.  

The  Family  Expenditure  Survey  looks  at  people’s  spending  habits  to  find  the  most  commonly  bought  ‘basket  of  goods’.    To  get  an  accurate  overall  inflation  figure,  we  need  to  know  how  significant  a  good  is.  If  salt  increases  in  price  it  will  have  much  less  impact  on  overall  inflation  than  if  petrol  increases  in  price.  

This  basket  of  goods  is  always  changing.  In  the  1940s,  it  included  items  like  Spam,  LP  records  and  Stout.  Today’s  basket  is  radically  different  with  new  items  like  iPads  and  mobile  phones  included.  Some  goods  are  still  there,  such  as  bread  and  milk  etc.  but  this  typical  basket  of  goods  is  being  constantly  updated  to  reflect  changes  in  spending  patterns.  

Secondly,  the  ONS  check  prices  of  goods  every  month  and  multiply  the  price  change  by  the  weighting  (how  important  it  is)  of  the  good.  

Understanding  Inflation  Data  

What  does  this  graph  show?  

• This  graph  shows  the  rate  of  inflation  between  1989  to  2010.  It  shows  that  prices  were  always  increasing  during  this  period.  

• In  1990,  prices  were  increasing  by  9%  a  year  (end  of  Lawson  boom)  • In  2000,  prices  were  increasing  by  only  1%  a  year  • In  2008,  prices  increased  by  5%  (due  to  rising  oil  prices)  • In  2009,  inflation  fell  and  prices  increased  by  only  1.5%  (due  to  

recession)  

Question:  What  happened  to  prices  between  1990  and  1994?  

• The  correct  answer  is  that  prices  increased  at  a  slower  rate.  The  inflation  rate  fell,  but  prices  still  went  up  (albeit  at  a  slower  rate).    

• (It  is  tempting  to  see  the  graph  and  say  prices  fell.  But,  it  is  just  the  rate  of  increase  that  fell.)  

Why  Does  Inflation  feels  higher  than  the  official  figure?  

Often  people  feel  that  inflation  is  higher  than  the  government’s  official  figure.  For  example,  we  may  have  inflation  of  4.5%,  but  we  see  petrol  prices  have  increased  15%,  food  7%,  and  heating  12%.  It  can  feel  inflation  is  under-­‐estimated.  

Firstly,  different  goods  and  services  don’t  increase  at  the  same  rate;  they  can  often  be  quite  different.  For  example,  while  petrol  prices  may  rise  15%,  the  cost  of  telephone  calls  may  be  falling  7%  and  price  of  computers  may  be  falling  11%.  

If  you  spend  a  high  %  of  your  income  on  heating,  fuel  and  food,  in  this  case  your  own  personal  inflation  rate  may  actually  be  higher  than  the  national  average.  This  is  because  the  goods  you  buy  are  increasing  faster  than  the  average.  If  you  are  a  pensioner,  you  may  not  benefit  from  the  falling  price  of  computers,  but  you  do  have  to  pay  more  for  heating.  Therefore,  the  average  inflation  rate  may  be  4.5%,  but  for  some  people  their  cost  of  living  is  actually  increasing  faster  than  this  'headline  rate'.  

This  means  some  people  who  see  their  pension  increase  in  line  with  inflation  may  actually  be  coming  worse  off.  

Psychology  of  Inflation  

Another  issue  is  that  rising  petrol  prices  can  make  front-­‐page  news,  but  when  they  fall  -­‐  it  doesn’t.  We  notice  price  rises  more  than  price  falls.    

Some  goods  like  petrol,  food  and  fuel  are  more  volatile.  Food  prices  can  fluctuate  due  to  the  weather.  Sometimes,  we  can  see  a  big  increase  in  food  prices  and  next  month  they  fall.  However,  it  is  the  price  rises  that  stick  in  the  mind  more  than  the  price  falls.  

The  psychology  of  inflation  may  also  depend  on  our  living  standards.  If  our  wages  are  rising,  then  the  price  rises  are  affordable.  But,  it  times  of  weak  wage  growth,  any  price  rise  feels  more  painful.  

Question:  Why  are  there  several  measures  of  Inflation?      

We  started  with  the  simple  definition  of  inflation;  inflation  is  an  increase  in  average  prices.  This  is  quite  straightforward,  however  it  depends  what  we  decide  to  include  in  the  basket  of  goods.  It  depends  which  prices  we  measure.    

We  have  many  different  measures  of  inflation,  including,  CPI,  RPI,  RPIX,  CPI-­‐T,  HCPI  (and  many  more)  

Firstly,  I  would  say  don’t  worry;  even  some  economists  would  struggle  to  name  and  define  all  these  innumerable  measures  of  inflation.  But,  they  are  all  based  on  the  same  principle.  They  just  include  or  exclude  different  factors.    

• RPI  includes  the  cost  of  mortgage  interest  rate  payments.  • CPI  –  T  excludes  the  temporary  effect  of  increasing  excise  duty  tax.  

In  2011,  the  government  increased  VAT.  This  means  prices  increased  because  of  the  higher  VAT.  However,  this  increase  in  prices  is  a  one-­‐off  increase.  Therefore,  in  the  next  year,  the  inflation  won’t  include  this  tax  increase.  Therefore,  it  is  useful  to  look  at  CPI-­‐T,  which  excludes  the  temporary  effect  of  taxes.  

Core  inflation  

One  useful  concept  is  the  idea  of  ‘core  inflation’.  This  is  the  inflation  rate  that  excludes  volatile  and  temporary  factors.  For  example,  core  inflation  excludes  one-­‐off  tax  increases,  petrol  and  food.  

This  is  important  because  if  we  get  a  rise  in  volatile  prices  (commodities  and  oil)  it  may  just  prove  to  be  temporary.    

For  example,  in  2008,  inflation  rose  to  5%  due  to  rising  oil  prices.  But,  12  months  later  inflation  had  fallen  to  less  than  1%  due  to  the  recession.  In  other  words,  the  oil  price  ‘spike’  proved  to  be  temporary.  We  can  say  underlying  inflation  was  low.  

Underlying  or  core  inflation  depends  primarily  on  the  strength  of  demand  in  the  economy.  A  good  guide  to  core  inflation  is  wage  inflation.  If  wage  inflation  is  muted,  core  inflation  is  likely  to  be  low  too.  

Chain  Weighted  Index  

Another  problem  with  measuring  inflation  is  that  changes  in  prices  may  alter  our  spending  patterns.  Suppose  there  are  two  goods  we  like  to  buy  -­‐  bus  tickets  and  train  tickets.  An  increase  in  train  tickets  may  cause  inflation  to  increase.  But,  the  higher  price  of  train  tickets  may  mean  we  stop  using  the  train  and  just  use  the  bus.  Therefore,  we  are  actually  not  affected  by  higher  train  fares.  A  chain  weighted  index  takes  into  account  these  changed  spending  patterns  resulting  from  higher  prices.  

Example  of  Different  Inflation  Rates  

This  graph  shows  how  some  goods  tend  to  be  quite  volatile.  Electricity  and  Gas  both  shows  a  very  rapid  inflation  in  2008  before  falling  in  2009.  

Note:  the  price  of  communication  has  often  been  falling.  This  is  due  to  technological  gains.  

If  a  person  spent  a  high  %  of  income  on  electricity  and  gas,  they  would  have  a  higher  personal  inflation  rate,  than  if  they  spent  a  high  proportion  of  income  on  communication.  

Q.  Do  governments  not  just  choose  the  most  convenient  inflation  rate?  

As  the  saying  goes  there  are  lies,  damned  lies  and  statistics.  By  choosing  your  inflation  rate,  it  can  give  a  quite  different  impression  of  the  economy.  One  issue  is  that  benefits  are  often  ‘index  linked’.  This  means  that  benefits  and  pensions  are  increased  in  line  with  inflation.  However,  RPI  inflation  could  be  6%,  CPI  4%,  and  CPI-­‐T  2.5%.  Therefore,  it  is  very  important  which  measure  is  used  to  set  benefits.  

Importance  of  Core  Inflation  

For  the  Bank  of  England  it  is  important  to  know  whether  inflation  is  likely  to  be  just  temporary  or  permanent.  Therefore,  looking  at  ‘core  inflation’  can  be  useful.  For  example,  in  2011,  we  had  a  spike  in  inflation  due  to  cost-­‐push  factors.  Usually  this  rise  in  inflation  to  5%  would  cause  the  Bank  to  increase  interest  rates  to  reduce  demand  and  economic  growth.  However,  in  2011,  the  economy  was  heading  towards  a  double  dip  recession,  and  the  Bank  felt  that  the  inflation  was  due  to  temporary  factors  (higher  tax,  higher  import  prices,  higher  oil  prices)  therefore,  they  could  leave  interest  rates  unchanged  because  core  inflation  was  low.  

Reasons  Why  Inflation  May  be  Under-­‐estimated  

1. People  are  buying  new  goods  and  services,  which  are  increasing  in  price,  but  not  included  in  the  basket  of  goods.  (e.g.  new  popular  iPhone  App)  

2. Some  people  may  have  a  higher  personal  inflation  rate,  because  they  spend  a  higher  %  of  their  income  on  gas  and  energy,  which  can  rise  faster  than  the  average  inflation  rate.  

Reasons  Why  Inflation  May  be  Over-­‐estimated  

1. Goods  increase  in  price,  but  the  price  increase  is  because  of  improved  quality.  If  a  new  version  of  mobile  phone  is  more  expensive,  is  this  inflation  or  a  reflection  of  improved  product  quality?  

2. When  goods  increase  in  price,  people  switch  to  alternatives  and  stop  buying  the  expensive  goods.  Therefore,  they  are  less  affected  by  rising  prices.  

Hyper-­‐inflation  

Hyperinflation  occurs  when  the  inflation  rate  is  very  high.  (Over  1000%).  This  means  that  prices  are  rising  so  rapidly  it  destabilises  the  economy.  

A  well-­‐documented  case  is  Germany  in  the  1920s.  Inflation  was  so  high  that  the  price  of  goods  would  go  up  almost  every  hour.  If  you  got  paid  in  the  morning,  you  had  to  buy  goods  straight  away  because  in  the  evening,  your  wages  couldn’t  buy  anything.      

When  inflation  is  this  high,  money  can  become  worthless  and  people  resort  to  a  barter  economy  (barter  economy  means  pay  with  physical  goods,  e.g.  if  you  have  hens  you  could  use  eggs  to  buy  a  train  ticket.  As  you  can  imagine,  this  makes  life  pretty  difficult).  

An  apocryphal  story  in  1920s  Germany  is  that  people  needed  so  much  money  they  had  to  carry  it  around  in  wheelbarrows.  When  left  outside  a  shop,  the  money  was  often  left,  but  someone  stole  the  wheelbarrow  because  it  was  more  valuable  than  the  1,000,000,000  marks.  

One  reason  economists  fear  inflation  is  that  if  inflation  becomes  embedded  and  takes  off,  it  can  lead  to  hyperinflation  and  economic  instability  as  people  lose  faith  in  the  monetary  system.  

Why  is  Inflation  Harmful?  

It  makes  sense  that  an  inflation  rate  of  1,000,000%  is  a  real  pain,  but  some  economists  get  very  worried  if  inflation  starts  to  increase  above  2%.  Why  is  even  moderate  inflation  considered  harmful?  

1. Uncertainty  and  Confusion.  The  argument  is  that  if  inflation  is  high,  firms  may  be  discouraged  from  investing  because  they  are  uncertain  about  future  prices  and  costs.  Low  inflation  creates  greater  certainty  in  the  economy.  It  is  argued  countries  with  low  inflation  tend  to  have  better  economic  performance  in  the  long-­‐run.  

2. Lower  international  competitiveness.  If  UK  inflation  is  higher  than  our  competitors,  it  means  UK  exports  will  become  less  competitive  leading  to  lower  demand  and  lower  growth  in  the  UK.  

3. Lack  of  Control.  There  is  a  fear  that  a  small  rise  in  inflation  could  cause  an  upward  spiral  and  inflation  getting  out  of  control.    For  example,  in  the  1970s,  higher  oil  prices  pushed  up  inflation;  this  led  to  higher  wages  and  a  wage  price  spiral  that  was  hard  to  contain.  

4. Unsustainable  Economic  growth.  Economists  would  rather  have  stable  sustainable  growth  and  low  inflation.  If  the  economy  grows  too  quickly  and  firms  push  up  prices,  this  growth  can  lead  to  a  boom  and  bust  economic  cycle.  (High  growth  followed  by  recession,  e.g.  Lawson  Boom)  

5. Fall  in  Living  standards.  If  people  have  fixed  incomes  or  savings  in  cash,  inflation  reduces  the  value  of  money  and  makes  them  worse  off.  This  is  why  some  people  say  inflation  is  like  taxation  without  regulation.  Inflation  reduces  the  value  of  your  savings.  However,  it  depends  on  the  real  interest  rate.  If  interest  rates  are  higher  than  inflation,  then  you  can  protect  your  savings.  

Deflation    

Deflation  occurs  when  prices  fall.  It  means  a  negative  inflation  rate  (e.g.  CPI  -­‐0.5%)  

If  Inflation  is  bad  does  that  mean  deflation  is  good?  

Unfortunately,  deflation  can  often  create  serious  problems  for  the  economy.  In  fact  economists  joke  (if  we  can  call  it  a  joke)  that  the  only  thing  worse  than  inflation  is  deflation.  

The  UK  experienced  deflation  in  the  1920s  and  1930s  (great  depression).  This  period  of  deflation  was  associated  with  falling  output  and  high  unemployment.  

Deflation  in  the  UK  during  the  1920s  and  1930s  was  a  period  of  high  unemployment  and  low  growth.    

The  post  war  boom  of  1945  to  mid  1970s  was  a  period  of  moderate  inflation.  

Problems  of  Deflation  

1. Lower  spending.  When  prices  fall,  people  delay  buying  goods  (they  wait  for  it  to  be  cheaper  next  year,  especially  for  expensive  luxury  goods).  Therefore,  this  delay  in  consumer  spending  leads  to  lower  demand  in  the  economy  and  this  can  lead  to  a  fall  in  output  and  higher  unemployment.  For  example,  Japan  experienced  deflation  in  the  1990s  and  2000s,  and  it  created  an  unwillingness  to  buy  goods  and  lead  to  a  prolonged  period  of  low  economic  growth.  (This  may  sound  counter-­‐intuitive  because  if  an  individual  good  is  cheaper,  we  will  buy  more.  However,  when  the  price  of  all  goods  are  falling,  we  find  people  often  spend  less  –  preferring  to  wait)    

2. Increase  real  value  of  debt.  Falling  prices  means  our  debt  is  harder  to  pay.  Most  people  have  some  kind  of  debt,  e.g.  mortgage,  credit  card  debt.  Deflation  increases  the  real  value  of  these  debts.  Usually  if  prices  fall,  firms  will  cut  wages.  Therefore  you  have  less  money,  but  you  still  have  to  pay  the  same  level  of  debt  back.  With  deflation,  people  have  to  spend  a  higher  %  of  their  disposable  income  on  debt  repayments.  Therefore  deflation  can  increase  the  number  of  bankruptcies  and  reduce  spending,  especially  amongst  people  with  high  levels  of  debt.    

3. Real  Wages  too  high.  Workers  resist  nominal  wage  cuts,  so  firms  cannot  afford  to  pay  workers  leading  to  higher  unemployment.    

4. Real  Interest  rates  too  high.  Nominal  interest  rates  can’t  fall  below  zero.  Therefore,  with  deflation,  real  interest  rates  become  high  and  it  becomes  more  attractive  to  save,  causing  a  fall  in  spending.    

5. More  difficult  for  prices  to  adjust.  With  a  moderate  inflation  rate,  it  is  easier  for  relative  prices  to  adjust,  but  with  deflation  this  is  more  difficult.  

Question:  But,  isn’t  it  good  that  new  technology  has  reduced  the  price  of  computers?  

Yes,  if  prices  fall  due  to  greater  productivity  and  technical  innovation  then  this  is  beneficial  as  we  get  lower  prices  but  also  greater  output.  Deflation  is  not  necessarily  a  bad  thing.  If  deflation  is  caused  by  technological  innovation  and  increased  productivity,  it  could  be  beneficial.  

However,  usually  deflation  is  caused  by  a  fall  in  aggregate  demand  and  low  growth.  Deflation  then  reduces  economic  growth  further.  

5.  Government  Spending  and  Tax  

What  does  the  government  spend  money  on?  

In  2010/11,  the  UK  government  spent  just  under  £700bn.  

The  main  areas  of  government  spending  are:  

• Social  security  £194bn  –  (pensions,  unemployment  benefit,  sickness  benefit,  housing  benefit)  

• Health  £122bn  • Education  £89bn  • Defence  £40bn  • Debt  Interest  £44bn  (interest  payments  on  UK  government  debt)  • Public  order  and  safety  £35bn  • Transport  £22bn  • EU  Membership  £6.4bn  

Spending  in  £  billions  

Out  of  interest:  

• Cost  of  Royalty  (Head  of  state)  £38.2  million  in  2010  

How  much  tax  does  the  Government  Get?  

In  2010-­‐11  

• National  insurance  £96bn  (a  type  of  income  tax  on  employers  and  employees)  

• Income  Tax  -­‐  £151bn  • VAT  -­‐£86bn  (20%  on  many  goods)  • Corporation  Tax  -­‐  £42bn  (tax  on  firms’  profit)  • Fuel  Duty  -­‐  £27bn  –  (petrol  tax)  • Business  rates-­‐  £23.8bn  (local  business  rates)  • Council  tax   -­‐  £25.7bn    • Capital  gains  tax  -­‐  £3.2bn  (profit  on  investment)  • Inheritance  tax   -­‐  £2.7bn  • Stamp  duty  land  tax  -­‐  £6.0bn  • Stamp  taxes  on  shares  -­‐  £3.0bn  • Alcohol  -­‐  £9.5bn  • Air  passenger  duty  -­‐  £2.2bn  • Insurance  premium  tax  -­‐  £2.5bn  • Climate  Change  Levy    -­‐  £0.7bn  • Vehicle  excise  duties  -­‐  £5.6bn  

Total  Tax  £550bn      

6.  Government  Borrowing  

Governments  are  very  good  at  spending  more  money  than  they  receive  in  tax.  If  they  spend  more  than  tax  revenues,  they  have  to  borrow  to  make  up  the  shortfall.  

Annual  Budget  Deficit  

In  a  particular  year,  the  government  may  have  to  borrow  a  certain  amount.  E.g.  2010-­‐11,  the  UK  public  sector  borrowing  was  approx.  £149bn  or  11%  of  GDP.  

This  deficit  is  because  the  government  spending  of  £700bn  is  greater  than  the  governments  tax  revenue  of  around  £550bn.  

This  means  the  government  borrowed  approximately  £2,400  per  person  in  the  country.    

National  Debt  

This  is  the  total  amount  the  government  owes.  For  more  than  300  years  (1693  to  be  precise),  the  UK  government  has  been  accumulating  debt.  In  2012,  the  government’s  total  debt  (called  public  sector  net  debt)  was  approximately  £1,000bn  or  64%  of  GDP  –  or  an  average  of  £10,000  per  person  in  the  economy.  

Question:  How  does  the  government  borrow?  

The  government  sells  bonds  to  the  private  sector.  (Also  called  gilts,  government  securities,  and  in  the  US,  Treasury  bills).  This  is  basically  an  “I  Owe  You”.  People  purchase  a  government  bond  for  say  £1,000.  In  return  the  government  pay  a  rate  of  interest  (say  5%)  until  the  end  of  the  loan  period  where  the  government  will  repay  the  full  £1,000.    

The  loan  may  last  for  3  months  to  30  years.  In  the  UK,  government  bond  sales  are  managed  by  the  Debt  Management  Office  

Q.  Who  Does  the  Government  Borrow  from?  

Essentially  it  is  the  private  sector  that  lends  money  to  the  government  by  buying  bonds.  For  example,  banks,  investment  trusts  and  pensions  will  buy  government  bonds.  If  you  have  a  private  pension,  indirectly  you  are  probably  lending  money  to  the  government  because  your  pension  fund  probably  holds  some  government  bonds.  Individuals  can  also  buy  government  bonds.  

Note:  In  some  circumstances,  a  Central  Bank  (e.g.  Bank  of  England)  can  purchase  government  bonds.  During  2009-­‐11,  the  Bank  of  England  pursued  a  policy  of  quantitative  easing.  This  involved  creating  money  electronically  and  buying  assets  such  as  government  bonds.  Therefore,  in  2012,  a  proportion  of  UK  government  debt  was  held,  not  by  the  private  sector,  but  the  Central  Bank.  

Does  the  Government  Borrow  from  abroad?  

Usually  governments  don’t  borrow  directly  from  abroad.  However,  foreign  investment  trusts  and  individuals  can  buy  UK  bonds.  Roughly  20-­‐30%  of  UK  government  debt  is  held  by  foreign  companies  and  individuals.  In  Japan,  most  Japanese  government  debt  is  held  domestically.  The  US  also  has  about  25%  of  its  public  sector  debt  owned  by  foreign  companies.  

Therefore,  when  we  talk  about  UK  public  sector  debt,  in  a  way,  we  are  borrowing  from  ourselves.  The  UK  government  borrows  from  the  UK  private  sector.  

Government  Bailouts  

Sometimes  a  government  may  have  to  borrow  from  abroad  when  they  face  a  crisis.  For  example,  in  the  1970s,  the  UK  government  had  to  borrow  from  the  IMF  to  meet  a  shortfall  in  the  budget.  In  2011,  the  European  debt  crisis  did  force  some  governments  to  borrow  from  abroad.  Countries  like  Ireland  and  Greece  were  forced  to  borrow  directly  from  financial  institutions  and  countries  abroad.  

Governments  will  obviously  try  to  avoid  needing  a  bailout.  It  is  embarrassing  to  have  to  ask  other  countries  to  bail  them  out.  Also,  if  the  IMF  lends  you  money  they  will  usually  require  certain  conditions  (like  increasing  tax  and  reforms  to  the  economy  which  may  be  politically  unpopular.)  

Difference  between  Trade  Deficit  and  Budget  Deficit  

It  is  important  to  remember  government  borrowing  is  completely  separate  from  the  trade  deficit  and  the  current  account  deficit  (The  trade  deficit  deals  with  imports  and  exports).  The  budget  deficit  deals  with  government  spending  and  tax  revenues.  

Central  Banks  and  Government  debt.      

Usually  the  government  borrow  from  the  private  sector.  But,  in  some  circumstances,  the  governments’  shortfall  can  be  met  in  a  different  way.  

The  Central  Bank  e.g.  the  Bank  of  England  can  create  money  to  buy  government  bonds.  This  is  a  rather  nifty  way  of  temporarily  dealing  with  your  debt  because  the  Central  Bank  literally  creates  money  out  of  thin  air  and  buys  government  bonds.  Thus  government  debt  is  being  financed  by  their  own  central  bank.    

This  occurred  during  the  process  of  quantitative  easing.  Central  Banks  in  US  and  UK  created  money  and  used  this  ‘created  money’  to  buy  Government  bonds.  

Note,  the  purpose  of  quantitative  easing  is  not  supposed  to  be  to  finance  the  deficit.  The  aim  is  to  increase  the  money  supply  to  boost  growth  and  reduce  interest  rates  to  improve  lending  and  investment  levels.      

But,  as  a  side  effect  of  quantitative  easing,  in  the  short  term,  the  government  doesn’t  have  to  borrow  so  much  from  the  private  sector.        

Also,  if  quantitative  easing  is  successful  and  increases  the  rate  of  economic  growth,  this  will  help  to  boost  tax  revenues,  which  will  help  to  reduce  government  borrowing.  

There  is  an  old  saying  money  doesn’t  grow  on  trees,  but  actually  Central  Banks  can  create  as  much  money  as  they  want.  For  them  money  can  be  created  out  of  thin  air.  

Question:  Why  doesn’t  the  government  print  money  to  pay  off  its  debt?  

This  is  the  great  temptation.  A  government  /  Central  Bank  with  own  currency  can  in  theory  print  money  and  pay  off  its  debt.  Yet,  this  has  the  potential  to  be  a  real  disaster.  (This  is  what  Weimar  Germany  did  in  the  1920s  leading  to  the  famous  case  of  hyperinflation.)  

Firstly,  printing  money  doesn’t  create  any  output.  We  have  the  same  number  of  goods  and  services.  If  you  double  the  amount  of  money  in  the  economy,  the  actual  output  will  stay  the  same.  

But,  if  you  double  the  money  supply,  people  have  more  cash  and  are  willing  to  pay  more  for  the  same  number  of  goods.  Therefore,  firms  will  put  up  prices,  and  we  will  just  see  a  rise  in  inflation.  In  a  very  simple  model,  doubling  the  money  supply  (amount  of  money)  will  double  prices.  Inflation  will  be  100%  but  output  will  be  exactly  the  same.  

Therefore  all  that  happens  is  that  things  are  more  expensive  and  the  high  inflation  creates  uncertainty.  

But,  there  are  other  problems  to  printing  money.  

• People  who  bought  government  bonds,  see  their  value  halve.  The  government  is  due  to  pay  them  £1,000,  but  inflation  has  reduced  its  value  so  it  is  really  only  now  worth  £500.  

• Increasing  the  money  supply  will  reduce  the  value  of  Sterling.  Foreigners  won’t  want  to  hold  UK  government  debt  because  the  value  of  sterling  is  falling  and  the  value  of  UK  bonds  decreases.  

• The  result  is  that  people  will  be  more  reluctant  to  hold  UK  government  debt  in  the  future  because  people  who  bought  bonds  have  become  worse  off.  

E.g.  who  would  want  to  buy  government  bonds  in  Zimbabwe  after  the  period  of  hyperinflation  and  fall  in  Zimbabwean  dollar?  

Therefore  printing  money  creates  inflation  and  reduces  the  value  of  bonds  and  savings.  This  makes  it  very  difficult  for  government  to  borrow  in  the  future,  because  investors  won’t  trust  governments  who  print  money  and  reduce  the  value  of  money.  

Question:  So,  if  printing  money  creates  inflation  why  has  the  UK  and  US  done  exactly  that?    Are  we  not  going  to  end  up  like  Weimar  Germany?      

In  2009-­‐11,  the  UK  and  US  pursued  quantitative  easing    -­‐  which  involved  increasing  the  supply  of  money  (in  particular  it  was  narrow  money  –  the  Monetary  Base  which  increased)    

(Technically  it  is  not  printing  money  but  the  overall  effect  is  pretty  much  the  same.)  Yet,  core  inflation  remained  very  low.  

Question:  How  Can  you  Print  Money  Without  Causing  Inflation?  

At  the  risk  of  over-­‐simplifying,  in  a  deep  recession  (liquidity  trap)  it  is  possible  to  increase  the  amount  of  money  in  the  economy  without  creating  inflation.  

The  money  supply  does  not  just  depend  on  the  amount  of  cash,  but  also  how  frequently  it  changes  hands.  In  a  recession,  money  will  not  be  spent  as  frequently,  and  banks  will  be  reluctant  to  lend.  

Therefore,  even  if  banks  see  an  increase  in  their  bank  balances  they  may  not  lend  it  to  consumers.  Also  consumers  will  be  saving  more  and  spending  less.  (People  are  metaphorically  keeping  more  under  their  mattresses.)  

Therefore,  the  Central  Bank  may  have  increased  the  amount  of  money  in  circulation,  but  it  is  being  stored  and  not  used.  

• In  a  period  of  economic  growth,  cash  is  frequently  being  used  and  changing  hands  frequently.    

• In  a  recession,  even  if  you  create  money  it  may  just  be  saved.  

If  you  print  money  during  a  period  of  normal  economic  growth,  it  is  almost  certainly  going  to  cause  inflation.  This  is  because  banks  will  lend  the  extra  money  and  people  will  spend  it.  

But,  in  a  recession,  in  a  time  when  people  hoard  money  and  it  is  not  being  spent,  it  is  very  unlikely  to  occur.  In  fact  the  Central  Bank  may  increase  the  money  supply  to  try  and  avoid  deflation.  

Some  argue  that  in  a  liquidity  trap,  with  a  falling  velocity  of  circulation,  a  Central  Bank  can  actually  create  money  and  pay  off  government  debt  permanently,  without  causing  inflation.  

This  graph  shows  that  during  the  period  of  quantitative  easing  2009-­‐2011,  M4  lending  to  private  sectors  was  often  negative,  much  lower  than  trend.  This  shows  that  quantitative  easing  failed  to  cause  a  boom  in  M4  money  supply  growth  as  some  economic  theory  would  predict.  

Note:  M4  is  called    ‘broad  money’.  It  includes:  notes  and  coins  plus  bank  and  building  society  deposits.  

Narrow  Money  Supply  

Notes  and  Coins  is  a  narrow  definition  of  money  –  as  it  suggests  it  is  the  amount  of  notes  and  coins  and  is  similar  to  an  old  definition  of  money  supply  called  MO.  

Controversy  

Of  course,  there  is  a  potential  problem  that  when  the  economy  recovers  and  banks  start  lending,  it  may  be  difficult  to  withdraw  all  the  extra  money  in  circulation  and  we  get  delayed  inflation.  But,  under  certain  circumstances,  Central  Banks  have  increased  the  money  supply  without  causing  any  inflation.        

In  the  UK,  quantitative  easing  didn’t  cause  underlying  core  inflation  to  increase.  However,  to  complicate  things  there  was  a  degree  of  cost  push  inflation  in  2011  (due  to  rising  petrol  prices  and  higher  taxes)  

Is  Government  Borrowing  Good  or  Bad?  

Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery.

Charles  Dickens, David Copperfield, 1849  

This  nugget  of  wisdom  may  apply  to  people  in  Dickensian  novels,  but  when  it  comes  to  borrowing,  governments  are  frequently  prolific  beyond  our  imagination.  

The  US  public  sector  debt  recently  passed  over  $15  trillion.  Many  would  have  difficult  comprehending  how  much  $15  trillion  actually  is.  

• Million  =  $1,000,000  • Billion  =  $1,000,000,000  • Trillion  =  $1,000,000,000,000  • 15  trillion  =  $15,000,000,000,000  

A  second  may  not  seem  a  long  time,  but  a  trillion  seconds  is  31,688  years  ago.  A  trillion  seconds  human  civilisation  had  not  begun.  A  billion  seconds  is  just  a  blink  of  the  eye  in  comparison  (31  years  ago)  

Anyway,  that  is  just  a  slight  diversion  to  give  an  indication  of  the  scale  of  the  government  borrowing.  

Problems  of  Government  borrowing    

Economist  suggest  government  borrowing  can  be  damaging  for  the  following  reasons:  

1. We  have  to  pay  interest  on  the  borrowing.  For  example,  the  UK  in  2011/12,  paid  roughly  £47bn  in  interest  to  bond  holders.  

2. It  can  be  a  burden  on  future  generations,  as  they  have  to  pay  interest  on  our  debt.  

If  borrowing  increases  too  much  (i.e.  an  unsustainable  amount  of  debt  to  GDP):  

1. Investors  may  be  less  willing  to  buy  government  bonds.  If  markets  think  that  the  Greek  government  may  default  (not  able  to  pay  back  bond  holders)  then  the  Greek  government  won’t  be  able  to  sell  bonds  to  finance  its  debt.  This  leads  to  a  fiscal  crisis.  

2. Higher  interest  rates.  If  people  fear  a  government  may  default,  their  debt  is  seen  as  more  risky.  To  compensate  for  the  risk,  interest  rates  on  bonds  will  have  to  increase.  If  people  trust  a  government  to  definitely  repay,  they  may  accept  a  low  interest  rate.  But,  if  people  worry  they  could  lose  money,  they  will  only  buy  if  interest  rates  are  higher.  

3. However,  higher  interest  rates  can  lead  to  lower  growth  and  more  unemployment.  Higher  interest  rates  also  increase  the  cost  of  borrowing  for  the  government.  

4. Inflation.  It  is  possible  that  if  government  borrowing  increases  too  much  they  may  be  tempted  to  increase  the  money  supply  to  finance  the  deficit,  which  causes  inflation.  This  will  also  weaken  the  value  of  the  exchange  rate.  

5. Crowding  out  of  private  sector.  If  the  government  borrow  from  the  private  sector,  there  will  be  fewer  funds  for  private  sector  investment.  Also,  if  borrowing  pushes  up  interest  rates,  higher  interest  rates  also  crowd  out  private  sector  investment.  

Question:  Is  Britain  Bankrupt?  

In  2007,  UK  public  sector  debt  was  £500bn.  In  2012,  this  had  increased  to  over  £1,000bn.  If  you  include  financial  sector  intervention,  debt  is  closer  to  £2,300bn    

If  you  include  future  pension  commitments  (ageing  population  and  governments  commitment  to  pay  pension),  the  fiscal  state  is  even  worse.  

However,  even  with  this  scale  of  debt,  Britain  is  not  bankrupt.  

Firstly,  this  level  of  debt  is  not  a  new  thing.  The  UK  has  been  through  higher  levels  of  public  sector  debt  in  the  past.  

This  graph  shows  that  after  the  two  world  wars,  the  UK  had  a  dramatic  rise  in  government  borrowing,  reaching  a  peak  of  240%  of  GDP  in  the  1950s.  

One  way  of  thinking  about  debt  is  how  much  do  you  have  to  spend  on  the  interest  payments  to  finance  the  debt.  In  the  UK’s  case,  debt  interest  payments  of  £45bn  a  year  sound  a  lot,  but  it  is  only  equal  to  about  3%  of  GDP.  Therefore  it  is  manageable.  

If  you  take  out  a  mortgage,  you  may  spend  30%  of  your  disposable  income  on  mortgage  payments,  but  you  don’t  consider  yourself  bankrupt.  It  is  a  manageable  amount.  

At  the  present  time  Britain  is  not  bankrupt  and  has  been  through  worse  in  the  past.  However,  just  because  the  UK  isn’t  bankrupt  doesn’t  mean  we  don’t  have  a  serious  level  of  government  borrowing  -­‐  a  level  that  is  unsustainable  in  the  long  term.  

What  does  Debt  as  a  %  of  GDP  mean?  

• If  you  have  an  income  of  £10,000  and  debts  of  £10,000.  Your  debt  is  100%  of  your  income.  

• If  your  income  doubles  to  £20,000  and  your  debt  increases  to  £12,000.  Your  debt  as  a  %  of  your  income  falls  to  60%  of  your  income.  

• Therefore,  an  increase  in  debt  is  not  so  bad,  if  your  income  increases  at  a  faster  rate.  

It  is  the  same  principle  with  government  debt  as  a  %  of  GDP.  

• GDP  is  national  income  (the  total  of  everyone’s  income  in  the  country)  

• Therefore,  if  GDP  rises  faster  than  debt,  the  debt  to  GDP  ratio  will  fall.  • Usually  Real  GDP  may  increase  by  about  2.5%  a  year.  Therefore  if  debt  

rises  by  2.5%  a  year  than  debt  as  a  %  of  GDP  stays  the  same.  • This  means  economic  growth  is  very  important  for  making  debt  more  

manageable.    

Rising  Debt  to  GDP  Ratios  

• After  the  recession  of  2008,  UK  debt  rose  at  a  very  fast  rate.  But,  GDP  fell.  Therefore,  we  saw  a  sharp  rise  in  the  ratio  of  debt  to  GDP.  

• The  worst  combination  is  rising  debt  and  falling  GDP.  This  occurred  for  many  European  countries  in  2008-­‐12  

Why  is  Debt  as  a  %  of  GDP  important?  

If  debt  to  GDP  stays  the  same,  we  will  typically  spend  the  same  %  of  tax  revenue  on  debt  interest.  Therefore,  we  don’t  need  to  increase  tax  rates.  

If  the  debt  to  GDP  ratio  increases,  we  may  have  to  increase  tax  rates  to  pay  the  higher  rate  of  debt  interest.    

Also,  if  debt  to  GDP  ratio  rises,  markets  may  worry  about  the  affordability  of  debt.  Therefore,  this  tends  to  push  up  interest  rates  making  it  more  expensive  for  the  government  to  borrow.    

Reducing  Debt  to  GDP  Ratios  

To  reduce  debt,  may  require  spending  cuts  and  higher  taxes.  However,  higher  taxes  could  cause  lower  economic  growth.  Therefore,  although  we  reduce  debt,  if  GDP  falls,  we  may  not  improve  debt  to  GDP  ratios.  It  can  become  a  vicious  cycle.  

Some  economists  argue  policies  of  fiscal  austerity  (spending  cuts)  can  become  self-­‐defeating  if  there  is  nothing  else  (e.g.  loose  monetary  policy,  devaluation)  to  boost  economic  growth.      

Bond  Yields  

“I  used  to  think  that,  if  there  was  such  a  thing  as  reincarnation,  I  wanted  to  come  back  as  the  president,  or  the  pope,  or  a  .400  baseball  hitter.  But  now  I  want  to  come  back  as  the  bond  market.  You  intimidate  everybody.”  

-­‐  James  Carville,  campaign  manager  for  US  President  Bill  Clinton.  

Bond  yields  are  frequently  mentioned  in  the  financial  news,  yet  it  is  a  topic  people  are  likely  to  have  only  a  vague  understanding  about.    

Bond  markets  can  send  governments  into  panic  and  create  devastation  in  an  economy,  but  why  are  they  so  important?  Is  it  good  or  bad  if  bond  yields  increase?  Why  do  bond  yields  rise  when  the  price  of  bonds  falls?  

Bond  Yields  and  Price  of  Bonds  

• Let  us  suppose  a  government  sells  a  30-­‐year  bond  worth  £1000.    • On  this  bond  the  interest  rate  could  be  set  at  5%  =  £50  per  year.  • You  could  buy  the  bond  and  hold  onto  it  for  30  years.  In  this  case,  you  will  

get  paid  £50  every  year  and  at  the  end  of  30  years,  the  government  will  pay  back  the  original  £1,000.  

However,  you  can  also  buy  and  sell  this  bond  on  the  bond  market,  e.g.  after  five  years  you  may  want  to  spend  the  money  so  you  can  sell  your  government  bond  to  someone  else.  They  will  then  own  it  and  receive  the  interest  payments  until  the  end  of  the  period.  

• If  more  people  want  to  buy  bonds,  the  market  price  will  increase.  For  example,  the  bond  may  increase  in  value  to  £1,500.  

• But,  the  government  will  still  only  pay  £50  a  month  interest.  Therefore  the  effective  bond  yield  is  50/1500  =  3.33%.  

• Therefore,  as  the  price  of  bond  rises,  the  effective  yield  falls.  

• However,  if  people  were  nervous  about  holding  government  bonds,  they  would  sell  bonds.  This  would  mean  the  price  would  fall.  

• The  government  bond  could  fall  in  price  to  £600.  However,  this  bond  still  pays  £50  a  year.  Therefore,  the  effective  interest  rate  is  50/600  =  8.3%  

• Therefore  as  bond  prices  fall  the  effective  yield  will  increase.    

What  Does  This  Mean?  

For  example,  if  investors  are  nervous  about  Greek  debt,  they  don’t  want  to  hold  Greek  bonds  unless  there  is  a  high  interest  rate  to  compensate  for  the  risk.  Therefore,  people  sell  Greek  bonds,  and  this  causes  interest  rates  to  rise  in  compensation.  

Higher  bond  yields  may  indicate  investors  fear  a  default  in  that  country.  

Are  Rising  Bond  Yields  Always  Bad?  

Rising  bond  yields  may  indicate  people  are  worried  about  a  countries  ability  to  repay  and  so  are  selling  bonds  and  demanding  higher  interest  rates.    Therefore  rising  bond  yields  can  indicate  government  debt  is  too  high  (e.g.  case  of  Ireland  and  Greece  in  2010)  

However,  there  is  another  reason  why  bond  yields  may  increase.  

• If  people  expect  higher  economic  growth,  they  will  also  expect  interest  rates  to  start  rising.    

• Therefore  government  bonds  may  be  sold,  as  people  want  to  buy  more  profitable  assets  (such  as  shares)  with  a  higher  yield.  

• Therefore  rising  bond  yields  may  occur  because  people  are  optimistic  about  the  future  and  are  expecting  an  upturn  in  the  economic  cycle.  

In  a  recession,  government  borrowing  increases.  You  might  expect  this  to  cause  higher  bond  yields  (people  worry  the  government  is  borrowing  too  much).  However,  often  this  doesn’t  occur.  In  a  recession,  investors  often  want  to  buy  government  bonds,  which  are  seen  as  safe,  rather  than  risky  private  sector  investment.  Therefore  in  a  recession,  we  often  see  bond  yields  fall,  until  the  economy  starts  to  recover.    

But,  if  governments  borrow  too  much  (like  Greece),  then  yields  will  rise  because  investors  fear  a  default.  

To  some  extent  it  depends  –  do  you  trust  the  government  to  repay?  Japan  has  borrowed  225%  of  GDP,  but  people  still  trust  the  Japanese  government  to  honour  debt  without  creating  inflation,  therefore  the  Japanese  keep  buying  Japanese  bonds.  (Japan  is  also  helped  by  high  levels  of  domestic  saving)  

EU  Debt  Crisis  

Question:  Why  did  bond  yields  on  UK  debt  fall,  whilst  bond  yields  on  other  countries  such  as  Spain,  Italy  and  Ireland  rose  rapidly?  

Firstly  in  2011,  the  UK  had  a  bigger  budget  deficit  than  all  these  countries.  Bond  Yields  in  the  Eurozone  rose  rapidly  because:  

• Markets  were  pessimistic  about  the  overall  prospects  for  Eurozone  debt.  Problems  in  Greece  showed  markets  that  being  in  the  Euro  was  no  guarantee.  Greece  partially  defaulted  on  its  debt,  a  rare  occurrence  for  a  sovereign  nation.  

• No  Lender  of  last  resort  in  the  Euro.  One  important  difference  between  the  UK  /  US  and  the  Eurozone  is  that  the  UK  and  US  have  a  Central  Bank  willing  to  act  as  lender  of  last  resort.  This  means  if  there  is  a  shortage  of  people  buying  bonds,  the  Central  Bank  is  willing  to  create  money  and  buy  bonds.  Therefore,  investors  don’t  fear  a  liquidity  shortage  in  the  UK.  But,  they  do  fear  this  in  the  Eurozone;  therefore  they  are  less  willing  to  buy  Eurozone  bonds,  pushing  up  interest  rates.    

To  Summarise  

1. If  investors  think  a  government  may  default,  this  will  reduce  demand  for  bonds  and  push  up  yields  (interest  rate)  

2. Bond  yields  also  change  depending  on  prospects  for  growth.  Higher  growth  tends  to  push  up  bond  yields  as  investors  sell  bonds  for  more  profitable  assets.  

How  Much  Debt  Can  a  Government  Borrow?  

There  is  no  simple  answer  to  how  much  a  government  can  borrow.  

• In  the  1950s,  the  UK  borrowed  over  200%  of  GDP  (helped  by  loan  from  US)  In  2012,  we  are  only  borrowing  64%  of  GDP,  but  it  is  a  different  situation.  

• Japan’s  national  debt  is  over  225%,  but  markets  don't  seem  worried  because  at  the  moment,  Japanese  savers  are  willing  to  buy  Japanese  governments  bonds.  

• In  Ireland,  markets  become  worried  when  debt  as  a  %  of  GDP  rose  to  over  100%  of  GDP.  

In  short  there  is  no  easy  answer  to  how  much  a  government  can  borrow.  

It  depends  on:  

• Do  people  want  to  lend  the  government  money?  (do  people  want  to  buy  bonds?)  E.g.  in  Japan  the  private  sector  has  a  large  appetite  for  buying  government  bonds.  

• Prospects  for  growth.  If  an  economy  is  forecast  to  grow,  it  makes  it  easier  to  pay  off  debt  and  reduce  the  debt  to  GDP  ratio.  If  an  economy  is  forecast  to  go  into  recession  (lower  output)  then  they  are  likely  to  get  lower  tax  revenues  and  it  becomes  harder  to  pay  off  debt.  

• Reputation  of  the  country.  If  a  country  has  never  defaulted,  investors  are  more  likely  to  trust  the  fact  that  the  bond  is  safe.  But,  if  you  get  a  reputation  for  defaulting  it  can  be  harder  to  attract  investors.  

• Does  the  government  have  a  credible  plan  to  reduce  the  budget  deficit?  If  a  country  is  paralysed  by  political  weakness  it  can  be  difficult  to  agree  on  politically  unpopular  tax  rises  and  spending  cuts.  

• Being  in  the  Euro  and  single  currency  seems  to  make  it  more  difficult  to  borrow.  Countries  in  the  Euro  have  less  room  for  manoeuvre;  they  can’t  ask  their  Central  Bank  to  buy  government  debt.  Also  they  can’t  devalue  the  currency  to  promote  greater  competitiveness.  

Q:  Why  Do  Economists  Suggest  Government  Borrowing  to  deal  with  the  problem  of  Debt?  

The  credit  crunch  was  caused  by  excess  borrowing  and  bad  loans,  therefore  why  does  the  government  start  borrowing  more?  Surely  they  should  be  doing  the  opposite?  

The  problem  with  the  credit  crunch  was  that  the  private  banking  sector  lost  money.  This  caused  a  fall  in  aggregate  demand  and  a  fall  in  GDP  (output).  

In  a  recession,  people  become  nervous  about  spending;  they  start  saving  more.  (E.g.  in  the  UK,  the  saving  ratio  rapidly  rose  from  1%  to  5%  at  the  start  of  the  recession.)  

For  an  individual  it  makes  sense  to  save  more  and  spend  less  when  you  could  be  made  unemployed.  

However,  if  everyone  in  an  economy  starts  saving  and  spending  less  it  causes  a  large  fall  in  economic  output,  higher  unemployment  and  a  deep  recession.  

The  economist  John  M  Keynes  argued  that  in  a  recession,  the  fall  in  private  sector  spending  needs  to  be  offset  by  a  rise  in  government  spending.  

If  the  government  do  nothing,  there  is  a  sharp  fall  in  spending  and  output  declines.  However,  by  borrowing  the  government  can  inject  money  into  the  economy  and  help  the  economy  recover.  When  the  economy  recovers  the  government  will  receive  higher  tax  revenues  and  can  spend  less  on  unemployment  benefits.  

Overall  borrowing  in  the  economy  is  not  increasing.  The  government  borrow  more,  but  they  are  compensating  for  the  rise  in  private  sector  saving.  

All  economists  do  not  accept  this  theory  of  Keynesian  economics.  However,  the  essential  argument  is  that  in  a  recession  with  mass  unemployment,  the  government  should  borrow  to  create  demand  that  is  not  there.  

In  times  of  growth,  the  government  should  reduce  its  borrowing.  

Q:  But,  doesn’t  Government  borrowing  reduce  the  size  of  the  private  sector?  

If  the  economy  is  growing  and  the  government  increase  spending  by  borrowing  from  the  private  sector,  it  will  mean  the  private  sector  have  less  funds  for  investment.  In  other  words,  the  government  increase  spending  but  we  get  a  corresponding  fall  in  private  sector  spending.  (This  is  known  as  crowding  out)  

However,  in  a  recession  it  is  different,  the  private  sector  want  to  save.  There  is  high  demand  for  government  bonds  because  these  are  seen  as  a  good  way  to  save  money.  Therefore,  in  a  recession,  the  government  is  just  trying  to  use  resources,  which  are  currently  idle.  The  government  is  not  crowding  out  the  private  sector  because  they  private  sector  are  not  investing.  

Question:  Does  Government  Borrowing  Increase  Interest  Rates?  

If  government  borrowing  increases  it  requires  more  people  buy  bonds.  If  the  economy  is  doing  well,  investors  may  not  want  to  buy  government  bonds  unless  interest  rates  on  bonds  increase.  Therefore  to  attract  people  to  buy  bonds,  interest  rates  need  to  rise  

However,  in  a  recession,  interest  rates  may  not  increase  because  there  is  a  high  demand  for  buying  government  bonds,  even  at  low  interest  rates.  (In  a  recession,  there  are  fewer  alternatives  for  investing  in  secure  trusts)  

In  the  above  diagram,  interest  rates  on  10-­‐year  bonds  increased  in  Ireland  and  Spain  because  markets  were  worried  about  the  government’s  ability  to  repay.  

In  the  UK,  interest  rates  actually  fell  from  Nov  07  to  Feb  2011  because  there  was  strong  demand  for  UK  bonds.  

Question:  What  is  the  Best  Way  to  Reduce  Government  Debt?  

The  problem  with  reducing  government  debt  is  that  it  can  cause  other  problems.  Suppose  a  government  decided  to  immediately  tackle  its  budget  deficit.  It  could  increase  tax  rates  and  cut  government  spending.  However,  the  effect  of  this  would  be  to  reduce  consumer  spending  and  overall  aggregate  demand.  Spending  cuts  would  lead  to  unemployment  and  higher  taxes  would  lead  to  lower  consumer  spending.  The  combined  effect  of  this  would  be  to  cause  lower  economic  growth.  

If  these  austerity  measures  did  cause  a  fall  in  economic  growth,  then  the  government  would  receive  lower  income  tax  and  have  to  spend  more  on  

unemployment  benefits.    Also,  lower  GDP  would  have  the  effect  of  increasing  debt  to  GDP  ratios.  

Credit  rating  agencies  often  downgrade  government  debt  on  forecasts  of  lower  economic  growth.  

When  economic  growth  is  very  strong,  then  it  is  much  easier  to  cut  government  spending  without  halting  an  economic  recovery.  

It  also  depends  on  what  the  government  cut  spending.  If  the  government  make  public  sector  workers  redundant  there  will  be  a  big  fall  in  spending  and  consumer  confidence.  However,  if  the  government  increased  the  retirement  age,  they  could  reduce  their  long  term  spending  commitments  on  pensions  without  adversely  affecting  economic  growth.  In  fact,  making  people  work  for  longer  may  actually  increase  productivity.  

It  may  be  very  unpopular  to  raise  the  retirement  age.  People  who  expected  to  retire  at  65  may  feel  it  is  unfair  to  suddenly  have  to  work  an  extra  5  years.  However,  from  one  economic  perspective,  it  would  be  a  way  to  reduce  government  borrowing  without  causing  a  fall  in  economic  growth.    

Why  Do  Attempts  to  Reduce  Debt  Cause  Rising  Bond  Yields?  

Several  European  countries  that  embarked  on  severe  austerity  programs  often  failed  to  reassure  markets  about  the  state  of  their  finances.  For  example,  spending  cuts  by  Greece  and  Ireland,  led  to  lower  economic  growth.  This  fall  in  tax  revenues  meant  markets  were  nervous  about  their  prospects  to  reduce  debt  to  GDP.  

It  is  an  irony,  markets  can  demand  austerity  measures  because  of  rising  government  debt,  but  then  markets  punish  countries  who  enter  into  recession  as  a  result  of  their  own  attempts  to  reduce  debt  levels.      

However,  it  is  possible  to  reduce  spending  without  causing  a  recession.  For  example,  Canada  in  the  1990s  had  a  large  budget  deficit.  Canada  cut  government  spending  ruthlessly.  However,  this  didn’t  cause  a  recession  because:  

• The  Canadian  currency  devalued  making  Canadian  exports  increase.  • Canada  benefitted  from  a  boom  in  the  US  economy.  • Monetary  policy  was  relaxed  (lower  interest  rates)  

This  shows  austerity  measures  can  work.  But,  it  helps  if  you  can  boost  demand  by  increasing  exports  or  loosening  monetary  policy.  Countries  in  the  Eurozone  don’t  have  this  option  because:  

• They  can’t  devalue  • They  can’t  pursue  an  independent  monetary  policy  • Other  European  countries  are  also  facing  low  growth.  

Example:  How  did  the  UK  Government  Respond  to  the  Great  Depression  in  the  1930s?  

The  stock  market  crash  of  1929  precipitated  a  dramatic  fall  in  output  around  the  world.  It  led  to  a  fall  in  output,  higher  unemployment  and  a  decline  in  trade.  As  a  result  government  borrowing  increased,  (income  tax  revenue  fell,  and  the  government  had  to  spend  more  on  unemployment  benefits)  

However,  at  the  time,  the  Treasury  economists  advised  the  government  they  needed  to  tackle  the  problem  by  reducing  government  borrowing.  At  the  time,  economic  orthodoxy  said  it  was  important  for  governments  to  run  balanced  budgets  and  not  borrow.  

Therefore,  in  1931  the  Ramsay  MacDonald  National  Government  cut  unemployment  benefits  and  increased  taxes.  (The  first  Labour  minority  government  got  elected  in  1929,  but  many  Labour  MPS  resigned  from  government  in  1931  over  cutting  unemployment  benefits.    The  new  coalition  government  was  mainly  Conservative  MPs  headed  by  Labour  MP  Ramsay  McDonald.)  

By  increasing  taxes  and  cutting  benefits,  it  led  to  a  further  fall  in  consumer  spending  and  lower  growth.  It  made  the  recession  deeper.    In  the  UK,  high  unemployment  persisted  until  the  start  of  the  Second  World  War.  

It  was  against  the  backdrop  of  the  Great  Depression  that  John  M.  Keynes  wrote  his  General  Theory  of  Employment.  It  is  quite  a  dense  work  and  definitely  not  light  reading.  But,  one  essential  idea  was  the  notion  that  in  recessions,  governments  needed  to  intervene  to  prevent  persistently  high  unemployment.  

The  irony  of  the  period  is  that  two  countries  did  pursue  a  dramatic  increase  in  government  spending  –  Germany  and  Japan.  In  these  countries,  unemployment  fell  as  government  spending  on  military  and  infrastructure  increased.  However,  it  is  important  to  note,  the  effect  on  unemployment  could  have  been  the  same  if  the  government  spending  had  been  on  education,  health  care  and  transport.  

7.  Balance  of  Payments  

The  balance  of  payments  is  concerned  with  the  flow  of  transactions  between  one  country  and  the  rest  of  the  world.  It  measures  the  level  of  imports  and  exports.  

There  are  two  main  components  of  the  Balance  of  Payments  

1. The  Current  account  –  This  measures  trade  in  goods  and  services.    2. Financial  /  Capital  account.  Flows  of  capital  (e.g.  money  deposits  in  

banks)  and  long-­‐term  investment.  

The  UK  has  a  current  account  deficit.  We  import  more  goods  from  China  than  we  export.  E.g.  if  you  look  at  many  electronic  goods  /  clothes  it  will  say  ‘Made  in  China’    

On  the  other  hand,  China  has  a  current  account  surplus  with  the  UK.  They  export  goods  to  us.  

Q.  What  Happens  when  there  is  a  current  account  deficit?  

It  means  we  are  buying  more  imports  of  goods,  therefore  foreign  currency  is  flowing  to  China.  However,  if  we  have  a  deficit  on  the  current  account,  this  needs  to  be  financed  by  a  surplus  on  the  financial  account.  This  could  involve  a  flow  of  currency  to  buy  financial  assets  or  long-­‐term  investment  

E.g.  China  may  buy  UK  assets  or  UK  government  bonds.  This  means  foreign  currency  comes  from  China,  which  enables  us  to  import  Chinese  goods.  

E.g.  The  US  has  a  substantial  current  account  deficit  with  China.    The  US  buys  cheap  manufactured  goods  from  China.  China  uses  this  accumulation  of  foreign  currency  to  buy  US  government  bonds  and  other  US  assets.  

Therefore  if  you  run  a  trade  deficit  (import  more  goods  than  export)  then  you  need  to  have  a  surplus  on  the  financial  account.  

Note:  a  current  account  deficit  is  completely  separate  to  government  debt.  

Q.  But,  what  happens  if  there  isn’t  a  financial  flow  from  China  to  UK.  What  would  happen  if  China  didn’t  want  to  buy  UK  assets  to  finance  the  trade  deficit?  

If  there  were  a  current  account  deficit,  but  no  flows  to  finance  it,  there  would  be  a  fall  in  the  exchange  rate.  The  demand  for  Chinese  currency  would  be  greater  than  Pound  Sterling.  Sterling  would  fall  in  value  making  UK  exports  cheaper.  If  exports  were  cheaper,  this  would  increase  demand  and  reduce  the  current  account  deficit.  

Therefore,  there  is  a  mechanism  to  ensure  the  balance  of  payments  balances.  E.g.  a  deficit  on  current  account  must  be  matched  by  a  surplus  on  the  financial  /  capital  account.  

Trade  Deficit  

When  talking  about  the  balance  of  payments,  people  often  refer  to  the  trade  deficit.  A  trade  deficit  implies  we  import  more  goods  than  we  export.    However,  the  trade  deficit  only  comprises  part  of  the  current  account.  We  need  to  also  consider  trade  in  services  (e.g.  insurance,  banking)  and  investment  incomes.  

Question:  Is  it  Harmful  to  have  a  current  account  deficit?  (Trade  deficit)  

Back  in  the  1960s,  there  was  a  popular  campaign  to  ‘Buy  British’.  Politicians  were  worried  about  the  UK  trade  deficit,  and  there  was  an  attempt  to  appeal  to  our  patriotic  sense  of  duty  and  buy  British  goods  rather  than  import  them  from  Japan.  The  problem  is  that  patriotic  duty  is  all  very  well,  but  when  your  British  Leyland  car  breaks  down  for  the  third  time  in  a  week,  German  and  Japanese  efficiency  looks  much  more  appealing  than  the  patriotism  of  buying  an  Austen  Minor.  

The  UK  has  had  a  current  account  deficit  pretty  much  ever  since  the  early  1980s.  

• You  could  argue  a  current  account  deficit  is  the  sign  of  an  unbalanced  economy;  a  trade  deficit  is  a  sign  our  exports  are  uncompetitive.  

• A  current  account  deficit  means  foreigners  are  owning  more  of  UK  assets,  e.g.  China  buying  UK  bonds  and  other  assets.  Russians  buying  UK  property.  

• The  deficit  may  be  unsustainable  if  we  can’t  attract  enough  financial  flows  to  pay  for  our  imports.  

However,  although  a  current  account  deficit  is  considered  problematic  it  is  much  less  important  than  in  the  1960s.    

• Globalisation  has  arguably  made  it  easier  to  attract  capital  flows  to  finance  the  deficit.  (Though  the  credit  crunch  showed  the  potential  limitations  of  this  argument.)  

• A  current  account  deficit  means  you  can  have  a  higher  standard  of  living  as  you  consume  more  imported  goods  and  services  (at  least  temporarily).  

Sometimes  countries  with  a  large  current  account  surplus  have  their  own  problems.  For  example,  Japan  has  a  persistent  current  account  surplus.  This  is  partly  because  of  the  competitiveness  of  their  exports,  but  also  because  the  Japanese  consumer  is  reluctant  to  spend  and  buy  imports.  In  Japan  a  large  surplus  is  an  indication  of  slow  growth.  

It  is  not  as  simple  as  saying  current  account  deficit  bad  -­‐  current  account  surplus  good.  

Current  Account  Balance  as  %  of  GDP  

However,  if  you  have  a  large  current  account  deficit  it  is  generally  seen  as  worrying  sign.  

Example  of  Large  Current  Account  Deficit  

In  2011,  Portugal  and  Greece  both  have  a  very  large  current  account  deficit  (close  to  10%  of  GDP)  

This  is  because:  

• Their  exports  have  become  uncompetitive  • In  the  Euro,  they  can’t  devalue  their  exchange  rate  to  improve  their  

competitiveness.  

8.  Interest  Rates  

Interest  rates  are  the  cost  of  borrowing  money.  If  you  get  a  loan  from  a  bank  they  may  charge  an  interest  rate  of  8%  a  year.  By  charging  interest,  the  bank  is  able  to  make  profit.  

If  you  save  money  in  a  bank  you  may  get  an  interest  rate  of  1-­‐4%.  This  is  your  reward  for  saving  money.  

In  a  very  simple  model  of  the  banking  system,  banks  attract  savings  by  paying  interest  to  savers  and  then  lend  the  money  at  a  higher  rate  to  people  who  want  to  borrow.    

The  difference  between  the  saving  and  lending  rates  is  effectively  their  profit  margin.  

Different  Types  of  Interest  Rates  

There  are  many  different  types  of  interest  rates  in  the  economy.  Some  of  the  most  common  include:  

• Interest  rate  on  your  current  account  (0-­‐1%)  –  you  get  instant  access  to  money,  but  the  bank  pays  little  interest  on  your  savings.  

• Saving  accounts  (4%)  –  In  a  saving  account  you  get  a  higher  rate  of  interest  rate,  but  you  might  have  restrictions  on  when  you  withdraw  money  (e.g.  7  day  notice).  This  makes  it  easier  for  banks  to  plan  and  lend  your  savings  out  to  other  people.  

• Mortgage  Loans  (5%)  –  A  mortgage  is  a  special  type  of  loan.  The  loan  is  secured  against  the  value  of  your  house  and  the  repayment  is  spread  over  a  long  period  of  time.  A  secured  loan  means  that  if  you  can’t  pay,  the  bank  can  claim  your  house  as  compensation.  This  makes  a  mortgage  loan  less  risky  for  a  bank  because  they  always  can  sell  your  house  so  they  don’t  lose  everything.  

• Unsecured  personal  loan  (8%).  An  unsecured  loan  is  not  guaranteed  by  any  asset.  It  is  more  risky  for  the  bank.  Therefore,  they  charge  a  higher  interest  rate  to  compensate  for  the  risk.  

• Credit  Card  Loan  (18%).  Borrowing  on  a  credit  card  can  be  very  expensive.    If  you  only  pay  the  minimum  each  month  you  can  find  the  amount  you  owe  continues  to  increase.  

• Pay  Day  Loans  /  Loan  Sharks  (100%)  Many  people  in  the  UK  don’t  have  a  bank  account.  This  makes  it  difficult  for  them  to  borrow  money.  Therefore  they  may  turn  to  pay  day  loans  or  unofficial  borrowing  channels.  These  lend  money  for  a  short  time  period  –  several  days,  at  effectively  very  high  interest  rates.  Loan  sharks  refer  to  unregulated  lenders  who  can  charge  very  high  interest  rates  to  people  without  access  to  ordinary  credit.    

• Interest  rates  on  government  bonds.  This  is  the  current  interest  rate  that  you  can  get  if  you  buy  government  bonds.  They  are  often  known  as  bond  yields,  because  it  is  the  amount  of  income  you  get  from  holding  a  bond.  The  bond  yield  on  a  10-­‐year  government  bond  is  4.11%  in  2011.  

Interest  Rates  and  the  Bank  of  England  

The  Bank  of  England  is  an  independent  body  responsible  for  looking  after  aspects  of  the  economy  (monetary  policy  and  inflation).  

The  Bank  of  England  can  control  the  base  interest  rate.  By  changing  the  base  interest  rate  they  can  affect  all  the  different  interest  rates  in  the  economy.  

• It  is  a  little  complicated,  but  the  Bank  of  England  acts  as  banker  to  the  commercial  banks.  (E.g.  If  Lloyds  TSB  is  short  of  money  they  can  borrow  from  the  Bank  of  England)  The  rate  Lloyds  TSB  borrows  from  the  Bank  of  England  is  known  as  the  base  rate.  

• If  the  Bank  of  England  increases  the  base  interest  rate,  it  makes  it  more  expensive  for  Lloyds  to  borrow  money.  Therefore,  Lloyds  TSB  are  likely  to  increase  their  own  interest  rates  for  savers  and  borrowers.  

• Therefore  indirectly  the  Bank  of  England  can  influence  all  the  main  interest  rates  in  an  economy.  

If  that  doesn’t  make  too  much  sense,  it  is  fine  to  just  know  the  Bank  of  England  set  the  base  rate  and  this  influences  all  the  other  interest  rates  in  the  economy.  

Q.  Why  Would  the  Bank  of  England  Increase  Interest  Rates?  

The  Bank  of  England  is  supposed  to  keep  inflation  close  to  the  inflation  target  of  2%.  Therefore  if  they  believe  the  economy  is  growing  too  quickly  and  inflation  is  increasing,  they  can  increase  interest  rates.  

This  increase  in  interest  rates  leads  to  slower  growth  and  helps  reduce  inflation.  

This  is  known  as  tightening  monetary  policy.  When  economic  growth  is  very  high,  it  is  like  a  tap  turned  to  full.  The  water  is  coming  out  very  fast,  but  because  the  water  is  coming  too  fast  it  may  spill  over  the  sink  (inflation)    

By  increasing  interest  rates,  the  Bank  is  trying  to  turn  down  the  tap  (reduce  the  growth  rate).  They  hope  to  keep  the  water  flowing  (positive  economic  growth)  but  avoid  the  water  coming  out  to  fast  (inflation).  

In  theory  the  bank  can  change  interest  rates  to  influence  the  speed  of  economic  growth  and  inflation.  But,  unfortunately  it  is  not  quite  as  simple  as  turning  a  tap  on  and  off.  

Impact  of  Increasing  Interest  rates  

If  the  Bank  thinks  inflation  is  increasing,  they  may  decide  to  increase  interest  rates  to  reduce  growth  and  inflationary  pressure.  

If  interest  rates  increase  it  affects  many  people  in  the  economy.  

• People  with  mortgage  payments  will  face  higher  monthly  mortgage  payments.  Therefore  they  will  have  less  income  to  spend.  

• It  will  be  more  expensive  to  borrow  money  (take  a  loan  out).  Therefore  it  will  discourage  firms  and  consumers  from  borrowing.  Therefore  this  will  lead  to  less  spending  and  investment.  

• Saving  will  give  a  higher  rate  of  return.  Therefore  saving  money  may  be  more  attractive  than  spending.  

• Higher  interest  rates  make  it  more  attractive  to  save  money  in  British  banks.  This  increases  demand  for  British  currency  and  therefore  the  value  of  the  pound  increases.  This  makes  exports  more  expensive  and  leads  to  lower  demand  for  exports  

The  overall  effect  of  higher  interest  rates  is  that  it  tends  to  reduce  spending  and  demand  in  the  economy.  It  leads  to  lower  economic  growth  and  can  help  reduce  inflation.  However,  the  lower  growth  can  cause  higher  unemployment.  

Impact  of  Cutting  Interest  Rates  

If  there  is  a  fall  in  output  and  an  increase  in  unemployment,  the  Bank  will  tend  to  cut  interest  rates  to  try  and  boost  economic  growth.  This  is  known  as  a  ‘loosening  of  monetary  policy’.  You  could  imagine  the  bank  opening  up  the  tap  to  encourage  the  flow  of  spending  and  economic  growth.  

Therefore,  in  theory,  the  Monetary  Policy  Committee  (MPC)  of  the  Bank  of  England  has  enormous  influence  over  the  economy.  If  they  want  to  target  higher  growth  they  can  cut  interest  rates,  if  they  want  to  reduce  inflation  they  can  increase  interest  rates.  

Interest  rates  used  to  be  set  by  the  government.  But,  governments  had  a  habit  of  cutting  interest  rates  just  before  an  election.  This  caused  higher  growth,  lower  unemployment,  cheaper  mortgage  payments  and  helped  make  them  more  electorally  popular.  However,  it  often  caused  inflation  to  occur.  Therefore  after  the  election  the  economy  experienced  high  inflation  and  it  was  difficult  to  reduce  it.  This  system  often  led  to  a  boom  and  bust  economic  cycle  (high  growth  and  inflation  followed  by  fall  in  output)  

Therefore,  the  responsibility  of  setting  interest  rates  was  given  to  the  Bank  of  England.  It  was  hoped  that  an  independent  body  would  not  be  influenced  by  political  consideration  and  avoid  boom  and  bust  cycles….  

For  several  years,  they  were  successful  –  during  1997-­‐2007  there  was  a  period  of  low  inflation  and  positive  economic  growth.  

However,  the  credit  crunch  and  great  recession  (2008-­‐11),  showed  the  limitation  of  relying  on  the  Bank  of  England  to  control  the  economy  through  just  using  interest  rates.  

With  one  policy  tool  (interest  rates)  it  is  not  possible  to  simultaneously  target,  inflation,  unemployment,  house  prices,  banking  lending  e.t.c.  

Problems  of  Monetary  Policy  

In  theory,  the  bank  can  target  economic  growth  and  low  inflation.  In  practise  it  is  often  much  more  difficult.  

Q.  Why  might  cutting  interest  rates  fail  to  increase  economic  growth?  

(Source  of  base  rate,  Bank  of  England  series  IUMAAMIH)  

In  the  middle  of  the  credit  crunch  in  2008,  the  bank  cut  interest  rates  from  5%  to  0.5%.  In  theory,  this  cut  in  interest  rates  should  increase  consumer  spending  and  investment  and  cause  strong  economic  growth.  However,  the  record  low  interest  rates  failed  to  return  the  economy  to  normal  economic  growth.  This  was  because:  

• The  recession  was  very  severe.  People  had  no  confidence  to  spend.  If  you  think  you  might  be  made  unemployed,  you  tend  to  increase  your  saving  and  not  buy  expensive  items  –  even  if  interest  rates  are  low.  

• Banks  had  lost  a  lot  of  money  in  the  credit  crunch.  The  banks  had  lost  vast  quantities  of  money  because  they  bought  into  US  mortgage  bundles  that  became  worthless  when  there  was  a  rise  in  US  mortgage  defaults.  Therefore,  the  banks  had  no  money  to  lend.  

• Although  base  rates  were  very  low,  it  was  very  difficult  to  get  a  loan.      In  other  words,  it  might  have  been  cheap  to  borrow,  but  it  was  hard  to  find  a  bank  who  would  actually  lend  you  anything.  

• Falling  House  prices.  In  2007,  house  prices  were  overvalued  and  after  the  credit  crunch  started  to  fall.  When  house  prices  fall,  consumers  lose  wealth  and  therefore  they  have  less  confidence  to  spend.  Falling  house  prices  are  also  bad  for  banks  that  now  lose  more  money  on  mortgage  defaults.  In  theory,  low  interest  rates  should  make  it  cheap  to  buy  a  house  (low  mortgage  payments).  But,  low  interest  rates  didn’t  stop  house  prices  falling  because  banks  became  very  strict  about  mortgage  lending.  

• Time  delays.  If  you  cut  interest  rates  not  everyone  benefits.  People  may  have  a  two  year  fixed  mortgage.  This  means  the  interest  rate  on  their  mortgage  won’t  change  for  two  years  when  they  remortgage.  

• If  you  remember  the  analogy  of  the  tap.  The  bank  can  turn  up  the  flow  of  water.  But,  in  practise  it  is  like  having  a  tap,  where  there  is  an  18-­‐month  time  delay  before  it  reacts  to  turning  it  on.  

• Commercial  banks  may  not  pass  on  the  base  rate  cut  to  consumers.  

(Source:  of  base  rate  Bank  of  England  series  IUMAAMIH  -­‐  SVR  BofE  series,  IUMTLMV)  

This  graph  shows  how  during  the  credit  crunch,  commercial  banks  kept  their  Standard  Variable  Rates  (SVR)  higher  than  the  Bank  of  England  base  rate.  When  the  Bank  of  England  cut  base  rates,  commercial  banks  didn’t  follow  suit.  

The  commercial  banks  didn’t  cut  their  SVR  rates  because  they  wanted  to  improve  their  liquidity  and  attract  more  deposits  rather  than  lend  money  out.    

The  Problem  of  Rising  Oil  Prices  

Q.  How  do  rising  oil  prices  affect  the  economy?  

• A  rapid  rise  in  oil  prices  leads  to  an  increase  in  costs  for  firms  (e.g.  transport  costs).  This  increase  in  costs  will  be  passed  onto  consumers.  This  leads  to  higher  inflation    

• However,  it  also  leads  to  slower  economic  growth.  Consumers  face  a  higher  cost  of  living  and  so  have  less  disposable  income  to  spend.  

• Therefore,  unfortunately,  rising  oil  prices  can  lead  to  both  inflation  and  lower  growth  at  the  same  time.    

• This  combination  of  inflation  and  lower  growth  is  sometimes  referred  to  as  stagflation.  Stagflation  occurred  in  the  1970s  after  the  oil  price  shocks.  

Question:  How  Should  we  Respond  to  Higher  Oil  Prices?  

In  the  short  term,  it  is  difficult.  

• The  MPC  could  increase  interest  rates  to  reduce  inflation,  but  growth  is  already  falling.  Higher  interest  rates  would  lead  to  even  lower  growth.  

• The  MPC  could  cut  interest  rates  to  boost  growth,  but  this  will  cause  inflation  to  be  even  worse.  

Basically,  rising  oil  prices  makes  everything  more  difficult.  We  have  to  accept  higher  inflation  or  lower  growth  or  both.  We  have  a  worse  trade-­‐off.      

Oil  prices  in  2008  caused  a  rise  in  inflation  to  5%.  But,  at  the  same  time  GDP  fell  dramatically.  We  had  similar  stagflation  in  2011,  with  rising  inflation  and  falling  economic  growth.  

However,  it  is  worth  remembering,  oil  prices  are  often  volatile,  so  the  inflation  many  be  temporary,  e.g.  at  the  start  of  2008,  inflation  was    5%.    By  the  end  of  2008,  inflation  had  fallen  to  0%.  

Therefore  Central  Banks  may  not  increase  interest  rates  when  inflation  is  caused  by  rising  oil  prices.  But,  it  can  be  unpopular  as  people  see  falling  living  standards  and  higher  prices.  

In  the  long  term,  higher  oil  prices  may  encourage  firms  to  develop  alternative  fuel  sources.  Consumers  may  be  encouraged  to  find  alternative  means  of  transport.  Therefore,  in  the  long  term  it  can  have  some  benefits.  

9.  Banking  System  

Banks  play  an  integral  role  in  the  modern  economy.  

• They  allow  you  to  deposit  your  savings  in  a  safe  place  and  earn  you  interest.  

• Banks  can  lend  money  to  firms  and  consumers.  This  enables  them  to  buy  expensive  items  and  invest.  Without  being  able  to  borrow  from  a  bank,  firms  would  find  it  very  difficult  to  invest  and  grow.    

• Economic  growth  would  be  very  low  if  banks  didn’t  lend  money  for  investment.  

Q.  How  Do  Banks  Work?  

• When  you  deposit  £1,000  at  a  bank.  It  doesn’t  keep  all  that  in  its  vaults  for  when  you  want  to  withdraw  it.  This  would  not  give  the  bank  any  profit.  

• What  the  bank  does  is  to  lend  most  of  this  (say  £900)  to  firms  and  consumers  who  want  to  borrow.  The  bank  charges  interest  to  firms  and  consumers  and  so  makes  profit  on  lending.  

• The  bank  relies  on  the  fact  that  its  depositors  won’t  simultaneously  ask  for  their  deposits  back.  

• In  fact,  banks  may  keep  less  than  1%  of  their  total  deposits  in  cash.  • A  traditional  building  society  encourages  people  to  deposit  in  saving  

accounts  so  it  can  lend  mortgages  to  its  customers.  

Q.  Why  Did  Banks  Lose  So  Much  in  Credit  Crunch?  

Basically  banks  made  loans  to  people  who  couldn’t  pay  them  back.  This  occurred  particularly  in  the  US,  where  banks  gave  mortgages  to  people  on  low  incomes  who  couldn’t  really  afford  them.  When  people  couldn’t  repay  their  mortgage,  the  banks  lost  money.  Also,  house  prices  fell  rapidly  so  the  bank  could  only  recoup  part  of  the  mortgage  loan  from  selling  the  repossessed  houses.  

Banks  also  got  involved  in  lending  money  to  each  other.  Some  European  banks  lost  money  because  they  had  effectively  lent  money  to  US  banks,  who  had  made  these  bad  loans.  

Question:  Why  does  the  government  bailout  banks  and  allow  manufacturing  firms  to  go  bankrupt?  Surely  good  honest  businesses  deserve  a  bailout  more  than  bankers  who  caused  the  credit  crunch?  

Most  people  would  say  your  average  businessman  does  deserve  a  bailout  more  than  your  average  banker.  However,  in  economics  what  people  deserve  is  not  always  the  best  solution.  

The  government  felt  it  was  necessary  to  make  sure  banks  didn’t  go  bankrupt  because  if  even  one  bank  went  bankrupt,  it  would  cause  a  severe  loss  of  confidence  and  everyone  would  consider  withdrawing  money  from  their  bank.  A  run  on  the  banks  (when  everyone  tries  to  withdraw  their  money)  would  cause  a  big  fall  in  the  money  supply  and  a  potentially  deep  recession.    

The  government  didn’t  want  to  bailout  the  banks,  but,  at  the  same  time,  they  didn’t  want  to  risk  letting  one  go  bankrupt  and  possibly  causing  a  loss  of  confidence  in  the  financial  system.    If  there  is  a  bank  panic,  it  could  have  a  devastating  impact  on  the  economy  –  affecting  everyone.  If  a  manufacturing  firm  goes  bust,  the  impacts  are  largely  confined  to  the  workers  and  related  firms.  

Governments  argue  it  is  beyond  their  capacity  to  bailout  out  all  private  manufacturing  firms.  Also,  it  is  difficult  for  the  government  to  know  which  firms  deserve  bailing  out.  The  fear  is  that  if  the  government  bailout  an  inefficient  firm,  and  the  firm  will  just  remain  inefficient.  

However,  there  are  times,  when  an  industry  is  so  large,  the  government  may  feel  it  is  worth  trying  to  keep  it  afloat.  For  example,  the  US  government  aid  to  General  Motors  in  2011.  

Q.  What  would  have  happened  if  the  government  allowed  Northern  Rock  to  fail?  

Northern  rock  lost  money  in  the  credit  crunch.  It  was  struggling  to  get  enough  funds  to  meet  its  commitments.  If  the  bank  had  failed,  depositors  would  have  tried  to  withdraw  their  money  (in  fact  there  were  long  queues  of  people  outside  Northern  Rock  banks  trying  to  do  that  before  government  announced  the  bailout).  

The  problem  is  that  the  bank  couldn’t  find  the  funds  to  pay  all  the  depositors.  The  money  was  tied  up  in  long-­‐term  mortgages  and  other  loans.  

• If  the  bank  couldn’t  pay  depositors  wanting  their  money  back,  this  would  cause  a  widespread  lack  of  confidence  in  the  banking  system.  Who  would  want  to  save  their  money  in  banks,  when  a  bank  can  go  bankrupt  and  you  lose  your  money?  

• It  would  encourage  other  savers  to  withdraw  money  from  their  banks  and  you  would  soon  see  long  lines  of  people  wanting  to  withdraw  their  money  from  their  banks.  

• Remember,  banks  don’t  actually  have  enough  money  in  their  reserves  to  immediately  pay  all  their  depositors.    

• Banks  only  keep  a  fraction  of  their  deposits  in  cash.  The  rest  is  lent  in  long-­‐term  loans  (e.g.  mortgages)  to  earn  the  bank  money.  Banks  know  that  in  normal  conditions  people  won’t  ask  for  all  the  money  back.    

The  banking  system  requires  confidence.  If  people  lose  confidence  then  the  banks  face  the  prospect  of  their  depositors  wanting  to  withdraw  all  their  money  at  the  same  time.  

Bank  Failures  in  the  1930s  Great  Depression  

In  the  1930s,  the  US  did  allow  many  banks  to  fail.  There  was  no  lender  of  last  resort  and  many  small  regional  banks  went  bust.    

After  people  lost  money  on  the  stock  market,  people  were  queuing  up  all  around  America  trying  to  get  their  money  out  of  banks.  But,  banks  couldn’t  meet  all  the  requests  for  money.  The  result  was  that  500  US  banks  failed  in  1932  alone.  This  meant  there  was  a  rapid  fall  in  bank  lending  and  fall  in  the  money  supply.  It  also  badly  affected  economic  confidence.  

This  number  of  bank  failures  undoubtedly  contributed  to  a  catastrophic  decline  in  money  supply  and  output.  The  decline  in  spending  led  to  a  further  rise  in  unemployment  and  a  prolonged  recession.  

Question:  Doesn’t  that  mean  Banks  can  take  risks  -­‐  knowing  if  they  mess  up  the  government  will  have  to  bail  them  out?  

Yes,  this  is  a  real  problem.  If  banks  gamble  and  make  high  profits  they  can  pay  themselves  large  bonuses.  But,  if  they  lose  money,  the  government  effectively  has  to  step  in  and  bail  them  out.  It  is  heads  you  win,  tails  the  taxpayer  loses.  

Arguably  the  fact  banks  don’t  have  to  be  fully  responsible  for  their  actions  encourages  the  risky  behaviour  we  saw  pre-­‐2008.    

Q.  But,  that  seems  wrong  

It  is.  This  is  why  there  are  calls  to  split  banks  into  different  sections  -­‐  retail  and  investment  branches.  In  that  case  the  government  can  guarantee  retail  savings,  but  not  the  riskier  investment  banks.  If  banks  get  involved  in  risky  investment  strategies,  these  parts  of  the  bank  can  be  allowed  to  fail.  

The  government  can  guarantee  ordinary  savings,  but  it  doesn’t  have  to  guarantee  bankers  speculating  on  credit  default  swaps.  However,  in  practise,  it  may  prove  more  difficult  to  split  up  banks.  Even  allowing  ‘risky  investment  banks’  to  fail  could  still  cause  a  powerful  loss  of  confidence  in  retail  banks.  E.g.  Lehman  Brothers  failed  in  October  2008,  causing  a  widespread  collapse  in  financial  confidence,  but  Lehman  Brothers  was  mainly  an  investment  bank  not  a  retail  bank.  

Question:  How  Did  the  Credit  Crunch  Occur?  

The  simple  answer:  Banks  lost  money  in  bad  investments.  This  was  often  money  they  didn’t  have.  In  other  words  they  borrowed  money  to  lend  to  other  people,  but  then  people  defaulted  (couldn’t  pay  back)  on  these  loans.          

Credit  Crunch  Explained  

 1. US  mortgage  lenders  sold  mortgages  to  customers  with  low  income  

and  poor  credit  (these  are  often  referred  to  as  sub-­‐prime  mortgages).    There  was  an  assumption  US  house  prices  would  keep  rising.  

2. Often  there  were  lax  controls  on  the  sale  of  mortgage  products.  Mortgage  brokers  got  paid  for  selling  a  mortgage,  so  there  was  an  incentive  to  sell  mortgages  even  if  they  were  too  expensive  and  a  high  chance  of  default.  

3. Mortgage  companies  also  sold  their  own  mortgage  loans  to  other  banks,  e.g.  British  and  European  banks  were  buying  these  ‘mortgage  bundles’  US  mortgage  companies  were  effectively  borrowing  money  to  be  able  to  lend  risky  sub-­‐prime  mortgages.  

4. Many  banks  were  buying  these  risky  sub-­‐prime  mortgage  loans  without  fully  realising  how  much  risk  they  were  exposing  themselves  to.  

5. Many  of  these  mortgages  had  an  introductory  period  of  1-­‐2  years  of  very  low  interest  rates.  At  the  end  of  this  period,  interest  rates  increased.  

6. In  2006,  after  a  period  of  very  low  interest  rates,  the  US  had  to  increase  interest  rates  because  of  concerns  over  inflation.  This  made  mortgage  payments  more  expensive.  Furthermore,  many  homeowners  who  had  taken  out  mortgages  2  years  earlier  now  faced  ballooning  mortgage  payments  as  their  introductory  period  ended.    

7. Faced  with  rising  living  costs,  many  homeowners  started  to  default  on  their  mortgage  –  they  couldn’t  pay  the  expensive  mortgage  they  took  out.  

8. As  people  couldn’t  pay  mortgages,  people  sold  houses  and  demand  for  buying  a  house  declined.  This  caused  a  fall  in  house  prices,  which  many  didn’t  expect.  

9. Banks  lost  money  because  people  defaulted  on  their  mortgage,  but  also  house  prices  were  falling  rapidly.  This  meant  they  couldn’t  recoup  their  losses  by  selling  the  homes  they  repossessed.  

10. Because  of  the  high  number  of  mortgage  defaults,  US  mortgage  companies  went  bankrupt.  But,  also  many  banks  around  the  world  lost  money  because  they  had  been  lending  money  to  these  US  mortgage  companies.  

11. Banks  lost  money,  therefore  to  recoup  their  money  they  stopped  lending  to  each  other.  It  suddenly  became  very  difficult  to  borrow  money  on  short-­‐term  money  markets.  

12. Banks  all  faced  greater  liquidity  problems.  (Hard  to  get  enough  money)  

13. This  difficulty  in  borrowing  affected  confidence.  It  encouraged  people  to  try  and  withdraw  their  savings  making  things  even  worse.  

Question:  Why  British  Banks  Were  Affected  

If  you  remember  the  traditional  model  of  a  bank.    -­‐  The  bank  attracts  deposits  (savings).  It  can  then  use  these  deposits  to  lend  to  business  and  consumers.  

• However,  in  the  boom  years  many  banks  became  greedy,  they  wanted  to  lend  more  mortgages  than  they  had  deposits.  

• Therefore,  banks  started  to  borrow  money  at  a  low  interest  rates  to  lend  at  a  higher  interest  to  mortgage  holders.  

• This  seemed  a  clever  way  of  making  money.  New  banks  which  used  to  be  building  societies  (like  Northern  Rock,  RBS  and  Bradford  &  Bingley)  scorned  the  traditional  model  of  banking  (lend  your  own  deposits).  They  wanted  faster  growth  and  more  profit.  

• It  was  fine  to  borrow  money  to  lend  when  interest  rates  were  low  and  credit  freely  available.  

• However,  the  credit  crunch  meant  that  suddenly  they  could  no  longer  borrow  money  at  low  interest  rates.  In  fact  they  couldn’t  borrow  money  at  all.  

• This  is  the  problem  Northern  Rock  had;  it  could  no  longer  borrow  money  to  finance  its  long  term  lending.  It  faced  a  shortage  of  liquidity  because  banks  no  longer  wanted  to  lend  to  each  other.  

• Also,  many  commercial  British  banks  had  bought  sub-­‐prime  mortgage  bundles  from  US  or  had  shares  in  other  banks  that  had  also  been  exposed  to  these  ‘toxic  debt’  bundles.  This  increased  their  losses.  

Q.  Why  Did  the  Credit  Crunch  Cause  the  Recession?  

• After  the  credit  crunch,  banks  found  themselves  very  short  of  cash  (liquidity).  Therefore,  banks  had  to  reduce  lending  to  business  and  consumers.  Therefore  business  investment  fell  and  consumer  spending  fell.  

• It  became  much  more  difficult  to  get  a  mortgage,  therefore  fewer  people  were  buying  houses.  This  caused  house  prices  to  fall  leading  to  lower  household-­‐wealth  and  lower  consumer  spending;  this  caused  a  fall  in  real  GDP.    

• The  frequent  bad  news  (e.g.  rumours  of  Northern  Rock  going  bust)  led  to  a  collapse  in  confidence  in  the  economy.  People  feared  unemployment  and  so  saved  more,  they  tried  to  pay  off  debt  and  reduced  their  spending.      

• The  global  nature  of  the  crisis  meant  there  was  a  fall  in  demand  for  UK  exports  because  other  countries  were  also  experiencing  lower  demand.  

10.  Exchange  Rates  

Exchange  rates  reflect  the  value  of  a  currency  compared  to  others.  

Depreciation  /  Devaluation  

A  depreciation  (also  referred  to  as  devaluation  in  a  fixed  exchange  rate)  means  a  currency  becomes  weaker.  For  example,  a  depreciation  in  the  pound  means  you  will  get  fewer  dollars  for  your  money.  

E.g.  of  depreciation  in  the  Pound  

• In  2007  £1  =  $1.7    • In  2009  £1  =  $1.5  

A  depreciation  in  the  pound  is  bad  news  for  UK  tourists.  It  means  visiting  abroad  will  be  more  expensive.  Imports  will  also  be  more  expensive.  

The  good  news  is  that  a  depreciation  will  make  UK  exports  appear  cheaper  to  foreigners.  This  will  help  increased  demand  for  UK  exports  and  boost  manufacturing  industry  (which  exports  a  high  %  of  output).  

Appreciation  

An  appreciation  in  the  exchange  rate  means  a  currency  becomes  stronger.  For  example,  it  means  one  pound  will  give  you  more  Euros  for  your  money.  

E.g.    • In  2010  £1  =  €  1.1    • In  2011  £1  =  €  1.3  

 • An  appreciation  in  the  Pound  Sterling  is  good  for  UK  tourists.  It  means  

when  we  travel  abroad  foreign  goods  appear  cheaper.  Imports  will  also  be  cheaper.  

• An  appreciation  makes  UK  exports  appear  more  expensive.  Therefore  there  will  be  lower  demand  for  UK  exports.  

Q.  Why  Does  an  Exchange  Rate  Increase  in  Value?  

The  value  of  the  Pound  will  increase  if  there  is  more  demand  or  lower  supply  of  Pound  Sterling  on  foreign  exchange  markets.    Various  factors  can  cause  an  appreciation  in  the  exchange  rate.  

Short  Term  Factors  

Higher  UK  interest  rates.  If  UK  interest  rates  increase  relative  to  other  countries,  then  saving  money  in  a  UK  bank  will  give  a  relatively  better  return.  If  you  have  a  large  investment  portfolio,  you  may  want  to  move  some  money  into  British  banks  to  take  advantage  of  the  higher  interest  rates.  To  save  money  in  the  UK  requires  an  increase  in  demand  for  Sterling  and  this  causes  the  exchange  rate  to  rise.  (This  is  known  as  hot  money  flows)  

Increased  Confidence.  If  investors  become  more  optimistic  about  the  UK  economy  –  e.g.  prospects  for  growth  increase;  this  will  tend  to  increase  demand  for  sterling.  Higher  growth  will  lead  to  higher  interest  rates  and  investors  will  in  the  future  move  savings  into  the  UK.  

Speculation.  Sometimes  exchange  rates  can  change  for  no  apparent  economic  rationale.  Investors  may  just  become  bullish  (optimistic)  about  a  currency,  causing  it  to  rise.      

Safe  Haven  Satus.  Related  to  speculation  is  the  idea  of  a  ‘safe  haven  currency’  For  example,  in  the  turmoil  of  the  Euro  crisis  in  2008-­‐11,  the  Swiss  France  became  a  very  attractive  option  for  currency  traders.  They  felt  Switzerland  was  immune  to  many  of  the  problems  in  other  European  countries;  this  caused  the  Swiss  Franc  to  appreciate  rapidly.  (In  fact  it  appreciated  so  much,  the  Swiss  Central  Bank  had  to  intervene  to  prevent  it  increasing  any  further.)  

Therefore,  sometimes,  a  currency  rises  because  investors  are  nervous  about  all  the  other  alternatives.  In  a  global  recession,  some  currencies  will  rise  despite  their  economy  being  weak.  

Long  Term  Factors  

Lower  Inflation.  If  the  UK  has  relatively  lower  inflation  than  other  countries,  our  exports  will  become  relatively  more  competitive.  This  will  lead  to  higher  demand  for  UK  exports  and  Pound  Sterling.        

Productivity  Growth.  If  a  country  sees  increased  productivity  and  improved  quality  of  its  goods,  their  exports  will  be  in  higher  demand.    This  will  cause  an  appreciation  in  the  exchange  rate.  

In  the  long  term,  relative  inflation  and  competitiveness  is  the  key  factor  in  determining  exchange  rates.  For  example,  in  the  post  war  period,  the  German  D-­‐Mark  steadily  appreciated  against  the  Pound  because  the  German  economy  was  becoming  relatively  more  efficient  and  competitive  than  the  UK.  

Q.  Is  it  Good  To  have  a  Strong  Exchange  Rate?  

A  strong  exchange  rate  is  often  seen  as  a  sign  of  a  strong  economy.  Therefore,  politicians  are  often  reluctant  to  see  their  currency  fall  in  value.  There  are  several  advantages  of  having  a  ‘strong  exchange  rate’  

• It  is  good  if  your  exchange  rate  appreciates  because  your  exports  are  becoming  more  competitive  and  you  have  an  efficient  economy.  In  this  case  the  currency  is  strong  because  your  underlying  economy  is  strong  and  competitive.  (E.g.  Germany  and  Japan  in  post  war  period).  

• The  prolonged  decline  in  Sterling,  in  the  post-­‐war  period,  was  due  to  the  fact  we  were  becoming  relatively  uncompetitive.  

• A  strong  exchange  rate  will  increase  living  standards  because  imports  are  cheaper.  This  is  important  if  countries  import  raw  materials  and  food.  

• A  strong  exchange  rate  will  help  keep  inflation  low.  

However,  sometimes,  an  economy  needs  a  depreciation  in  the  exchange  rate.  To  maintain  a  strong  exchange  rate  can  be  counter-­‐productive.  

If  an  economy  has  high  unemployment,  low  growth,  low  inflation,  uncompetitive  exports  and  a  current  account  deficit  –  this  is  an  indication  the  currency  is  overvalued.  In  this  case  a  depreciation  can  help  increase  demand  for  exports,  boost  economic  growth  and  help  reduce  unemployment.      

Example  -­‐  Greece  in  Euro  

Since  joining  the  Euro  in  2000,  Greek  exports  had  become  uncompetitive  because  of  rising  wages  and  inflation  –  relative  to  Germany  and  northern  Europe.    By  2010-­‐11,  Greece  had  a  large  current  account  deficit,  low  growth,  and  high  unemployment.  However,  they  couldn’t  devalue  the  exchange  rate  to  restore  competitiveness.  This  led  to  persistently  low  growth,  which  aggravated  their  existing  debt  problem.  

By  contrast,  the  UK  wasn’t  in  the  Euro.  In  2009,  the  Pound  depreciated  by  20%  to  restore  lost  competitiveness.  This  helped  minimise  the  effect  of  the  great  recession  on  the  UK  economy.        

Example  –  UK  in  ERM  and  Black  Wednesday  1992  

Whenever  we  have  a  bad  day  in  the  economy,  we  tend  to  refer  to  it  as  a  ‘black  day’.    

We  have:  

• Black  Monday  • Black  Tuesday  • Black  Thursday  

It’s  not  very  imaginative,  a  bit  like  calling  every  scandal  ‘something  gate’  

Anyway,  Black  Thursday,  is  an  interesting  example  of  what  can  happen  when  a  government  tries  to  maintain  a  strong  exchange  rate.  

• In  1992,  the  UK  was  in  a  deep  recession.  Output  was  falling  and  unemployment  close  to  3  million.  

• The  UK  was  also  in  the  Exchange  Rate  Mechanism.  This  involved  keeping  the  value  of  the  currency  at  a  fixed  level.    Roughly  £1  =  DM  3  

In  1992,  foreign  currency  traders  thought  that,  because  the  economy  was  in  recession,  this  value  of  Sterling  was  too  high.  Therefore  private  investors  were  selling  pounds.  

However,  the  government  were  committed  to  keep  the  Pound  at  a  certain  level.  Therefore  they  had  to  intervene  in  the  foreign  exchange  market.  To  prevent  the  value  of  the  Pound  falling,  they  did  two  things.  

• They  bought  Pound  Sterling,  using  its  own  foreign  currency  reserves.  • They  increased  interest  rates  to  make  it  more  attractive  to  save  money  in  

UK,  and  hopefully  increase  the  value  of  Sterling.  

However,  there  were  three  problems.  

1. Interest  rates  were  too  high  for  the  economy  because  the  economy  was  in  recession.  The  economy  needed  a  cut  in  interest  rates,  but  the  government  was  doing  the  opposite  to  protect  the  value  of  the  pound.  This  made  the  recession  much  deeper  and  more  painful.  In  particular  high  interest  rates  made  mortgage  payments  very  expensive.  

2. Markets  didn’t  believe  the  government  could  persist  with  high  interest  rates.  They  knew  interest  rates  were  far  too  high  and  was  causing  misery  for  homeowners.  

3. Markets  felt  the  Pound  was  overvalued  and  the  government  were  fighting  a  lost  cause  only  to  try  and  save  political  face.  

Investors  like  George  Soros  basically  were  betting  the  government  would  be  forced  to  devalue.  They  were  able  to  make  billions  of  pounds  profit  by  selling  pounds  and  buying  foreign  currency  from  the  British  government.  

• On  one  dramatic  day,  the  pound  was  again  falling  below  its  fixed  rate.  • The  government  increased  interest  rates  to  15%.  A  record  for  interest  

rates;  it  was  certainly  completely  unprecedented  for  the  middle  of  a  recession.    

• By  increasing  interest  rates  to  15%,  the  government  hoped  to  show  that  they  would  do  everything  in  their  power  to  maintain  the  UK  in  the  Exchange  Rate  Mechanism.  

• However,  markets  reacted  in  shock  and  disbelief.  How  could  you  have  interest  rates  of  15%  when  the  housing  market  was  collapsing  and  the  economy  in  recession?    

• Rather  than  save  money  in  British  banks  to  take  advantage  of  higher  interest  rates,  investors  continued  to  sell  Pounds.  

• A  few  hours  later,  the  government  realised  its  gamble  had  failed.  There  was  nothing  left  they  could  do  to  maintain  the  value  of  the  Pound.  They  

had  run  out  of  reserves  and  increasing  interest  rates  had  not  worked.  Therefore,  the  government  announced  that  they  would  leave  the  ERM.  

• Interest  rates  were  cut,  and  the  value  of  the  Pound  fell  20%  on  the  foreign  exchange  market.  

The  government  lost  billions  to  investors  like  George  Soros.  But,  the  decision  to  give  up  a  fixed  exchange  rate  helped  the  economy  to  recover.  

• After  the  devaluation,  exports  become  more  competitive  and  lower  interest  rates  reduced  the  burden  on  mortgage  holders.  After  cutting  interest  rates  and  devaluing  the  exchange  rate,  the  economy  recovered  from  the  recession.  

In  this  situation  the  economy  needed  a  devaluation.  Inflation  was  not  a  problem.  The  problem  was  low  growth  and  high  unemployment.  

Since  1992,  the  UK  government  have  not  targeted  the  value  of  the  exchange  rate  but  allowed  the  currency  to  ‘float’  i.e.  let  it  be  set  by  market  forces.  

A  strong  exchange  rate  is  good  if  it  is  caused  by  a  competitive  economy.  But,  to  artificially  keep  the  exchange  rate  above  its  market  value,  usually  causes  significant  economic  problems.  

One  benefit  of  this  ERM  crisis  was  that  this  experience  of  being  stuck  in  a  fixed  exchange  rate  at  the  wrong  level,  was  a  factor  in  discouraging  the  UK  from  entering  the  Euro.  At  least,  in  the  ERM,  you  can  devalue.  But,  with  a  single  currency,  that  is  not  possible.  

11.  The    Euro  

The  Euro  is  a  bold  experiment  to  replace  individual  currencies  with  a  single  European  currency  –  the  Euro.  

As  well  as  a  single  currency,  countries  in  the  Eurozone  have  the  same  interest  rate  (monetary  policy)  set  by  the  European  Central  Bank  (ECB).  

It  means  that  if  the  UK  joined  the  Euro,  we  would  no  longer  set  our  own  interest  rate,  but  it  would  be  set  by  the  ECB.  

Q.  What  are  the  Benefits  of  Joining  the  Euro?  

• It  makes  it  easier  for  business  and  consumers  to  travel  around  the  Eurozone.  You  don’t  lose  money  changing  currency  and  trying  to  carry  several  currencies.  

• It  is  easier  to  compare  prices.  With  all  goods  priced  in  Euros  it  is  easier  to  compare  between  different  countries.  

• It  eliminates  fluctuating  exchange  rates.  60%  of  our  trade  is  with  the  EU.  An  appreciation  in  the  Pound  can  make  UK  exports  uncompetitive.  However,  in  the  Euro  there  would  be  no  more  fluctuations  in  the  exchange  rate  with  Euro  members.  Stable  exchange  rates  would  arguably  encourage  investment.  

• Encourage  harmonisation.  The  hope  was  that  being  a  member  of  the  single  currency  would  encourage  greater  economic  harmonisation.  With  a  single  currency  there  are  supposed  to  be  greater  incentives  to  keep  inflation  low  and  government  borrowing  low.  

Q.  Why  Has  the  UK  not  joined  the  Euro?  

Even  the  most  ardent  Euro  enthusiast  would  find  it  difficult  to  argue  the  UK  would  have  been  better  off  in  the  Euro.  There  are  numerous  difficulties  of  being  in  the  Euro.  

1. Interest  Rates  would  have  been  wrong  for  the  UK.  In  the  Euro,  interest  rates  are  set  for  the  whole  Eurozone  area.  Therefore,  if  the  UK  experienced  a  deep  recession,  the  ECB  may  not  cut  interest  rates.  Therefore  we  could  have  high  interest  rates  when  we  need  to  boost  economic  growth.  

2. No  Independent  Monetary  Policy.  After  the  Recession  of  2008-­‐09,  the  UK  pursued  quantitative  easing.  This  involves  increasing  the  money  supply  and  buying  government  bonds.  This  helped  to  boost  growth  (or  at  least  prevented  a  deeper  recession).  In  the  Euro,  the  Central  Bank  cannot  do  this  so  there  is  less  flexibility.  It  would  have  been  more  difficult  for  the  UK  to  respond  to  the  great  recession  without  having  an  independent  monetary  policy.  

3. Lose  ability  to  devalue  currency.  In  the  Euro  you  cannot  devalue  against  other  Euro  members.  Therefore,  if  your  economy  becomes  

uncompetitive,  the  only  solution  may  be  a  prolonged  period  of  deflation  and  lower  growth.  After  the  credit  crisis,  the  Pound  Sterling  depreciated  20%  against  the  Euro.  To  some  extent,  this  helped  the  UK  economy  recover.    But,  many  other  Euro  economies  suffered  because  their  exports  were  overvalued  and  they  couldn’t  devalue.  

4. Higher  Bond  Yields.  If  the  UK  was  in  the  Euro,  we  would  have  had  higher  bond  yields  on  government  debt.  This  is  because  in  the  Euro,  there  is  no  lender  of  last  resort  (ECB  are  unwilling  to  buy  bonds.)  Therefore  markets  fear  liquidity  shortages  in  the  Eurozone;  this  tends  to  push  up  interest  rates.  

5. The  UK  is  more  sensitive  to  interest  rates.  The  UK  has  one  of  the  highest  rates  of  homeownership.  Many  in  the  UK  have  a  large  variable  mortgage  rate.  This  means  when  interest  rates  increase,  it  affects  UK  households  significantly  more  than  European  countries  where  people  are  more  likely  to  rent  a  house.  

6. Deflationary  Pressures.  Countries  in  the  Euro  have  needed  to  pursue  fiscal  austerity  (spending  cuts)  because  of  rising  bond  yields.  But,  this  causes  lower  growth,  and  there  is  no  policy  (e.g.  devaluation)  to  help  boost  growth.    Therefore,  countries  in  the  Euro  have  many  factors  contributing  to  low  economic  growth  and  deflationary  pressures.  

Q.  What  would  make  a  single  currency,  such  as  the  Euro,  work?  

1. Similar  Inflation  Rates.  The  biggest  problem  in  the  Eurozone  is  that  some  countries  have  had  higher  inflation  (e.g.  higher  wage  increases).  This  has  made  them  uncompetitive,  leading  to  lower  exports  and  lower  growth.  But,  they  can’t  devalue  to  restore  competitiveness.  Therefore,  the  Euro  needs  countries  with  similar  inflation  rates  and  a  good  deal  of  economic  harmonisation.  

2. Fiscal  Union.  True  fiscal  union  would  mean  that  countries  shared  a  common  Eurobond.  There  would  be  no  Italian  bonds  or  German  bonds  –  just  a  Eurobond.  This  means  the  responsibility  of  debt  would  be  shared.  

3. Geographical  Mobility.  A  single  currency  needs  a  great  deal  of  geographical  mobility.  E.g.  if  unemployment  is  high  in  Alabama,  it  is  relatively  easy  for  a  worker  to  move  to  another  US  state  where  there  are  more  job  vacancies.  However,  in  the  Euro,  it  is  more  difficult  for  a  Spanish  worker  to  move  to  Germany  to  get  a  job.  (For  example,  language  barriers,  difficulty  of  moving.)  

4. Fiscal  Transfers.  If  some  areas  were  lagging  behind  the  rest  of  the  Eurozone,  they  would  need  greater  fiscal  transfers  to  try  and  overcome  geographical  unemployment  and  harmonise  economic  growth  between  the  different  regions.  

5. Limits  on  government  borrowing.  The  debt  levels  of  Greece  were  unsustainable,  precipitating  the  Euro  debt  crisis.  To  be  in  the  Euro,  it  will  be  necessary  for  governments  to  stick  to  certain  budget  levels.  However,  sticking  to  budget  levels  may  constrain  fiscal  policy  and  cause  lower  economic  growth  in  certain  circumstances.  

12.  Globalisation  

Globalisation  refers  to  how  different  economies  are  becoming  closer  and  more  integrated.  Features  of  globalisation  include:  

• Greater  trade  between  different  countries  • Migration  of  labour  between  different  countries,  e.g.  workers  travelling  

from  Eastern  Europe  to  work  in  UK.  • Growth  of  global  multinational  companies  who  have  a  worldwide  reach.  • Growth  in  importance  of  organisations  like  the  IMF  and  World  Bank.  • Economies  more  closely  linked.  A  recession  in  one  country  tends  to  affect  

all  the  others.    

Globalisation  is  not  a  completely  new  phenomenon;  when  Marco  Polo  discovered  an  early  trade  route  to  China;  he  was  an  early  pioneer  of  globalisation.  You  could  say  the  whole  of  history  is  a  gradual  process  of  globalisation.  The  UK  population  is  a  potpourri  of  immigrants  from  Celts,  to  Vikings,  Romans,  Normans  and  later  immigrants  from  old  British  Empire.  It  is  just  that  in  the  last  50  years,  certain  factors  have  speeded  up  the  process  of  globalisation,  such  as:  

• Better  communication.  • Better  transport  making  it  easier  to  travel.  • Improved  technology,  which  has  effectively  reduced  the  distance  between  

people.  • Growth  of  regional  trading  blocks  (e.g.  NAFTA,  EU)  • Importance  of  free  trade  to  global  economic  growth.  

Even  in  the  nineteenth  century,  Japan  pursued  a  policy  of  ‘self-­‐sufficiency’  -­‐  the  idea  that  they  would  produce  everything  they  needed  and  have  no  or  little  contact  with  foreigners.  However,  in  their  post  war  economy,  Japan  has  become  one  of  the  world’s  biggest  exporters,  despite  having  few  natural  resources.  Their  economy  has  become  based  on  the  features  of  globalisation.  

Q.  Is  Globalisation  beneficial  or  harmful?  

Globalisation  is  quite  a  general  concept  and  so  evaluating  its  relative  merits  is  difficult.  Opponents  of  globalisation  argue  that:  

• Growth  of  multinational  companies  reduces  choice  and  makes  it  more  difficult  for  small  local  businesses.  Because  of  globalisation,  there  is  a  danger  of  cultural  homogeneity.  

• Globalisation  has  increased  environmental  degradation.  The  use  of  raw  materials  has  led  to  a  rapid  decline  in  natural  resources  such  as  the  destruction  rain  forests  and  bio  diversity.  

• The  process  of  globalisation  has  exacerbated  global  inequality,  with  the  poorest  regions  in  sub-­‐Saharan  Africa  not  benefitting  from  the  growth  in  living  standards  felt  in  the  developed  world.  

• Globalisation  has  arguably  enabled  Multi-­‐National  Corporations  to  exploit  low-­‐paid  workers  in  developing  countries.  

However,  others  defend  the  process  of  globalisation.  

• Globalisation  had  helped  increase  efficiency  of  production  leading  to  lower  costs  and  prices.  

• Greater  specialisation  enables  economies  of  scale  and  lower  costs.  This  leads  to  lower  prices  for  consumers.  

• Many  poor  countries  have  seen  a  growth  in  living  standards  due  to  the  benefits  of  trade.  For  example,  many  South  East  Asian  and  Latin  American  economies  have  witnessed  rapid  growth  in  GDP  and  economic  welfare  in  recent  decades.  

• There  is  no  reason  why  the  process  of  globalisation  has  to  lead  to  environmental  problems.  The  emphasis  is  for  governments  to  promote  growth  and  development  whilst  also  protecting  the  environment.  

• MNCs  may  seem  to  pay  low  wages  in  developing  economies.  But,  often  these  wages  are  higher  than  working  on  the  land.  Supporters  argue  it  is  better  to  offer  low  paid  work  than  no  work  at  all.  

• Free  movement  of  labour  and  capital  give  greater  flexibility  to  economies,  for  example,  it  can  help  deal  with  labour  shortages  in  key  areas.    

Globalisation  can  create  strong  emotions,  but  it  should  be  remembered  that  the  process  of  globalisation  is  rather  vague.  Globalisation  can  be  a  force  for  good;  it  can  also  exacerbate  existing  problems.  It  depends  how  it  is  implemented.  

13.  Free  Trade  

Free  trade  means  that  there  are  no  tariffs  (tax)  on  imports  and  exports.  Free  trade  means  that  it  will  be  easier  and  cheaper  to  buy  goods  from  abroad.  

Also  free  trade  implies  removing  other  barriers  to  trade  like  complex  forms  and  regulations,  which  increase  the  effective  cost  of  trade.  

In  the  past,  countries  have  often  put  tariffs  on  imports  making  them  more  expensive.  This  is  usually  to  protect  domestic  industries.  For  example,  British  farmers  may  complain  butter  from  abroad  is  too  cheap.  If  the  government  places  tariffs  on  imports  of  butter,  this  will  increase  demand  for  British  butter.  

Free  trade  tends  to  be  one  of  those  topics  where  economists  are  more  enthusiastic  than  non-­‐economists.  

Q.  Why  do  economists  generally  favour  free  trade?  

• Lower  Prices.  Removing  the  tariffs  on  imports  means  goods  will  be  cheaper;  this  increases  the  living  standards  of  consumers.  

• Exporters  who  have  a  comparative  advantage  will  be  able  to  export  more  abroad.  This  creates  jobs  in  these  exporting  industries.  Comparative  advantage  means  they  are  relatively  better  at  producing  it.  (Lower  opportunity  cost)  

• Free  trade  enables  countries  to  concentrate  on  producing  what  they  are  relatively  best  at.  For  example,  Saudi  Arabia  will  concentrate  on  producing  oil,  Japan  electronics,  and  the  UK  offering  education  and  financial  services.  It  is  more  efficient  to  concentrate  on  what  you  are  best  at  producing,  rather  than  trying  to  produce  every  good  you  might  need.  

• Specialisation  is  more  efficient.  If  Japan  specialises  in  electronics  and  cars  it  can  have  a  larger  scale  production.  This  larger  scale  production  enables  economies  of  scale  (lower  average  cost  with  increased  output).  For  example,  there  is  little  point  in  Iceland  having  a  major  car  industry.  It  won’t  be  efficient.  It  makes  more  sense  to  export  fish  and  use  revenues  to  buy  the  small  number  of  cars  they  need.  

• More  competition  is  good.  In  the  1970s,  the  UK  had  a  small  number  of  car  firms.  These  were  relatively  uncompetitive.  Globalisation  gives  consumers  greater  choice,  meaning  domestic  monopolies  have  to  become  more  efficient  or  go  out  of  business.  

Q.  Why  Do  People  Oppose  Free  Trade?  

1.  Job  Losses.  Sometimes  free  trade  may  lead  to  highly  concentrated  job  losses.  For  example,  if  you  remove  tariffs  on  imports  of  cars,  a  UK  car  firm  may  go  out  of  business  leading  to  hundreds  of  job  losses.  Therefore,  the  firm  and  workers  may  want  to  retain  tariffs  to  protect  the  business  and  jobs.  

Overall  the  economy  would  benefit  from  free  trade  and  lower  prices  of  cars.  However,  people  won’t  protest  to  make  cars  5%  cheaper.  People  will  protest  about  losing  their  jobs.  Therefore,  there  are  often  powerful  pressure  groups  supporting  tariff  barriers.  

Free  trade  often  leads  to  structural  change,  which  in  the  short  term  can  lead  to  unemployment.  This  process  of  adapting  to  international  competition  can  be  painful  in  the  short  term  and  in  certain  areas  of  the  economy.  

2.  Not  Fair  on  Developing  Economies.  The  theory  of  comparative  advantage  states  that  you  should  specialise  in  what  you  are  relatively  best  at.  For  many  developing  economies  this  may  be  agricultural  products  (sugar,  coffee,  tea).  However,  if  you  just  produce  sugar  and  coffee,  the  economy  is  unbalanced.  There  is  less  possibility  for  growth  (when  incomes  rise,  people  don’t  tend  to  buy  more  food.)  Also,  you  are  subject  to  fluctuations  in  the  price  of  sugar.  A  developing  economy  may  want  to  promote  manufacturing  industries  and  have  greater  diversity.  

In  the  short  term,  these  new  industries  may  be  unable  to  compete  with  established  multinational  companies.  The  argument  is  that  tariff  protection  gives  these  new  industries  a  chance  to  develop.  

Many  developed  economies  had  a  period  of  tariff  protection,  therefore  it  is  unfair  we  don’t  allow  developing  economies  the  chance  to  have  some  tariff  protection  whilst  they  try  and  diversify  their  economy.  

Conclusion  on  Free  Trade  

Generally,  economists  favour  free  trade.  However,  there  may  be  occasions  when  they  support  specific  tariffs.  The  case  for  infant  industries  in  developing  economies  is  one  example.  

However,  a  big  problem  for  developing  economies  is  that  many  developed  economies  have  high  tariffs  on  agriculture.  For  example,  the  EU,  Japan  and  US  all  have  high  tariffs  on  different  agricultural  items.  This  makes  it  difficult  for  developing  economies  that  produce  and  export  these  agricultural  goods.  

Free  trade  in  agriculture  would  help  many  poor  developing  economies  (especially  those  who  are  net  exporters  of  food).  However,  there  is  great  political  resistance  to  removing  tariff  barriers  in  agriculture  in  the  developed  world.  

World  Trade  Organisation  (WTO)  

The  WTO  is  designed  to  help  resolve  trade  disputes  and  promote  free  trade  amongst  members.  

Q.  Why  is  the  WTO  so  controversial?  

Arguably  promoting  free  trade  may  harm  developing  economies.    Critics  argue  that  by  supporting  free  trade,  they  place  the  interests  of  the  developed  economies  above  poorer  developing  economies.  

Is  That  Fair?  

Supporters  of  the  WTO  argue  that  promoting  free  trade  is  one  of  the  best  ways  for  promoting  greater  economic  welfare,  even  in  developing  economies.  They  point  to  countries  that  have  seen  improvements  in  living  standards  through  economic  growth  and  greater  trade.      

International  Monetary  Fund  (IMF)  

The  IMF  can  be  seen  as  a  global  bank.  It  can  help  economies  in  crisis.  For  example,  if  a  country  has  a  budgetary  crisis  the  IMF  can  provide  a  loan  to  help  deal  with  the  crisis.  This  gives  investors  more  confidence  and  helps  avoid  liquidity  crisis.  The  IMF  can  also  give  advice  on  policies  necessary  for  an  economy  to  develop  and  maintain  stable  economic  growth.  

Criticisms  of  IMF  

When  giving  funds  the  IMF  usually  insist  on  certain  criteria  to  be  met.  E.g.  if  a  country  needs  to  borrow  money,  they  will  insist  on  spending  cuts,  tax  increases  in  addition  to  receiving  a  loan.  Also,  the  IMF  often  insists  on  free  market  reforms  such  as  privatisation  and  deregulation  to  make  an  economy  more  efficient.  They  may  also  insist  on  tackling  inflation  (through  higher  interest  rates)  and  devaluation  to  restore  competitiveness.  

These  policies  are  often  controversial  because  they  can  lead  to  job  losses,  recession  and  greater  inequality.  Critics  argue  the  IMF  doesn’t  consider  the  impact  of  their  free  market  policies  on  poverty  and  spending  on  social  services.  

Supporters  of  IMF  

Defenders  of  the  IMF  say  that  they  are  unpopular  because  they  only  get  asked  in  a  real  crisis.  When  you  have  a  budget  crisis,  any  policy  is  going  to  be  unpopular  because  there  is  no  easy  fix.  They  argue  that  when  giving  a  loan,  it  is  important  to  make  sure  that  reckless  borrowing  is  not  encouraged,  otherwise  the  problem  is  likely  to  be  repeated  in  the  future.  The  IMF  says  that  it  is  easy  for  local  politicians  to  blame  an  external  organisation  (the  IMF)  for  the  economic  pain.  But,  in  a  crisis  there  is  no  real  alternative.  

14.  Housing  Market  

The  housing  market  is  apparently  one  of  the  most  popular  topics  of  conversation  at  dinner  parties.  At  the  dinner  table,  there  will  be  probably  some  people,  secretly  (or  openly),  very  happy  their  house  is  worth  three  times  more  than  when  they  bought  it.  By  contrast,  younger  people  will  probably  be  miserable  about  how  expensive  property  is,  and  how  difficult  it  is  to  get  on  the  property  ladder.  

A  paradox  of  the  UK  housing  market  is  that  we  know  there  is  a  shortage  of  housing  and  we  would  like  houses  to  be  cheaper.  But,  at  the  same  time  when  new  housing  schemes  are  proposed,  there  is  often  strong  local  opposition  (e.g.  protect  green  belt  land)  therefore,  in  the  UK,  we  rarely  build  sufficient  houses  to  meet  demand.    

Q.  Why  is  the  Housing  Market  Important  to  the  Economy?  

• When  house  prices  are  rising,  it  increases  the  wealth  of  householders.    • Rising  house  prices  and  wealth  make  people  feel  more  confident  to  

borrow  and  spend  (they  could  always  sell  their  house  if  necessary)  • If  prices  rise,  some  households  may  take  equity  withdrawal  (re-­‐mortgage  

their  house  and  take  out  a  bigger  loan  so  they  can  spend  more.)  • Overall,  rising  house  prices  tend  to  increase  consumer  spending  and  

cause  higher  economic  growth.  E.g.  rising  house  prices  in  the  1980s  contributed  to  the  Lawson  boom  and  high  economic  growth.  

• In  the  2000s,  rising  house  prices  encouraged  banks  to  lend  more,  contributing  to  a  credit  bubble  and  bust.  

Falling  House  Prices  

• If  house  prices  fall,  the  opposite  happens.  Consumer  confidence  falls  causing  lower  consumer  spending  and  lower  growth.    

• Also,  when  house  prices  fall,  people  and  banks  will  experience  negative  equity.  (People  owe  more  than  their  house  is  worth.)  This  is  another  factor  which  reduces  spending.  

• Falling  house  prices  frequently  makes  front-­‐page  news  (just  pick  up  a  copy  of  Daily  Mail  and  Daily  Express).  It  is  the  biggest  form  of  wealth  and  affects  a  large  proportion  of  the  population  

Q.  If  house  prices  fall  shouldn’t  it  be  cheaper  to  buy  and  help  give  people  more  disposable  income?  

Yes,  houses  will  be  cheaper  and  this  will  help  first  time  buyers.  But  the  majority  of  people  are  already  homeowners;  falling  prices  will  only  help  the  small  number  who  are  buying  for  first  time.  Most  people  will  feel  worse  off  if  prices  fall.  

Why  Are  UK  House  Prices  Volatile?  

UK  House  prices  are  notoriously  volatile.  It  often  seems  we  never  remember  the  previous  booms  and  busts,  but  we  experience  a  repetition  of  past  cycles.    

Reasons  for  House  Price  Volatility  

1.  Limited  Supply  

When  house  prices  rise,  we  can’t  easily  increase  supply  to  meet  demand.  It  takes  time  to  build  houses  (especially  in  UK  with  strict  planning  legislation)  If  demand  for  cars  increase,  firms  can  just  supply  more,  but  when  demand  for  houses  rise,  it  just  leads  to  higher  prices.  

2.  Changing  Interest  rates.  

A  small  change  in  interest  rates  has  a  big  effect  on  people’s  mortgage  payments.  If  interest  rates  increase,  people  may  be  unable  to  afford  a  mortgage  so  they  have  to  sell.  Lower  interest  rates  makes  buying  more  attractive,  increasing  demand.  In  other  countries,  more  homeowners  choose  fixed  rate  mortgages;  therefore,  they  are  less  sensitive  to  interest  rate  changes.  But,  in  the  UK,  variable  mortgages  are  more  popular  and  therefore  changes  in  interest  rates  can  significantly  affect  the  demand  and  price  of  houses.  

3.  We  Take  Risks  to  Buy  

Because  UK  house  prices  are  so  expensive,  people  often  take  out  mortgages  which  require  a  big  %  of  their  disposable  income.  Therefore,  changes  in  the  economy  can  soon  affect  our  ability  to  pay  the  mortgage.  

Graph  showing  mortgage  payments  of  first  time  buyers  can  take  between  28%  and  70%  of  take  home  pay.  

4.  Volatility  in  Mortgage  Lending.  

Before  2007,  banks  were  very  liberal  in  giving  mortgages.  You  could  get  a  100%  mortgage  (i.e.  needed  no  deposit),  or  a  self-­‐certification  mortgage  (i.e.  you  didn’t  have  to  prove  your  income,  enabling  you  to  borrow  more  than  you  could  afford)    

However,  after  the  credit  crisis,  banks  were  short  of  money  so  they  became  very  strict  in  lending  mortgages.  When  it  was  easy  to  get  a  mortgage,  house  prices  rose  rapidly.  When  it  was  difficult  to  get  a  mortgage,  demand  and  prices  fell.  

5.  Boom  and  Bust  in  Economic  Cycle.  

If  the  economy  goes  into  recession,  demand  for  houses  will  fall.  When  growth  is  high,  people  have  the  confidence  to  borrow  more.  If  you  fear  unemployment,  you  won’t  buy  a  house.      

6.  Speculators  

Rising  prices  encourage  people  to  try  and  make  capital  gains  (benefit  from  rising  prices).  When  prices  are  rising,  there  are  more  buy  to  let  investors  pushing  up  prices  further.  But,  when  prices  fall,  speculators  are  likely  to  sell  their  houses  to  prevent  a  fall  in  their  wealth.  

7.  Poor  Memories.  

People  often  have  poor  memories  and  during  a  boom  forget  that  house  prices  can  fall.  They  assume  that  house  prices  will  go  on  rising  forever.  

Q.  Why  Are  UK  House  Prices  So  Expensive?  

In  London  house  prices  are  roughly  six  times  average  earnings.  But,  most  banks  will  only  lend  you  a  mortgage  three  times  your  income.  

Despite  the  fall  in  house  prices  between  2008-­‐09,  many  young  people  still  can’t  afford  to  buy  a  house.  In  the  US,  Spain  and  Ireland,  house  prices  fell  considerably  more  than  in  the  UK.  Against  some  expectations,  UK  house  prices  didn’t  fall  as  much  as  you  might  expect.  

The  quick  answer  is  that  the  UK  still  has  a  shortage  of  housing.  Demand  is  greater  than  supply  and  this  keeps  prices  high.  

In  the  boom  period  of  the  2000s,  Ireland,  Spain  and  the  US  also  had  a  boom  in  building  houses.  Higher  prices  encouraged  firms  to  build  more  houses.  In  Spain  they  were  building  up  to  450,000  homes  a  year.  In  the  UK,  we  didn’t  have  an  increase  in  house  building.  We  actually  built  record  lows  of  less  than  150,000  houses  per  year.  

In  Spain,  Ireland  and  US,  there  are  many  unsold  houses  depressing  prices.  The  UK  still  has  a  shortage  

The  UK  population  is  growing  faster  than  we  are  building  new  homes.  Unless  we  build  more,  houses  prices  will  remain  relatively  more  expensive  than  countries  where  supply  is  greater.  

Q.  Why  Don’t  we  Build  More  Houses?  

The  simple  answer  -­‐  Not  in  my  back  yard.  

Most  people  would  say  it  is  good  to  build  more  houses  to  meet  rising  demand.  However,  if  a  new  property  development  is  proposed  in  their  local  area,  typically  there  is  strong  local  opposition.  Opposition  to  new  houses  is  based  on  fear  of  congestion,  overuse  of  public  services,  and  loss  of  green  space.    

There  is  also  a  monetary  incentive  to  oppose  building  new  houses    -­‐  if  you  don’t  build  new  houses,  it  increases  the  value  of  your  existing  homes.  If  supply  increases,  the  price  will  be  lower.  People  who  want  to  buy  a  new  house  are  in  the  minority.  

Probably  the  biggest  opposition  to  house  building  comes  from  a  desire  to  protect  local  communities  from  ‘over  expansion’.  It  is  understandable  people  wish  to  protect  local  green-­‐belt  land.  But,  the  national  effect  is  that  we  end  up  building  fewer  houses  than  we  need.    

UK  Economic  History  

This  section  offers  a  quick  look  through  UK  economic  history,  showing  the  main  trends  in  economic  thought  and  how  economics  has  affected  the  lives  of  British  people.  

1.  Victorian  Period    

Economics  in  the  mid  to  late  Nineteenth  Century  was  characterised  by:  

1.  Minimal  government  intervention  in  the  economy.    

Victorians  believed  in  laissez-­‐faire  and  that  generally  the  government  shouldn’t  intervene  in  the  workings  of  the  free  market.  Taken  to  its  logical  conclusion,  the  government  refused  to  give  free  corn  to  Ireland,  during  the  potato  farming.  Respected  civil  servants  like  Charles  Trevelyan  –  on  one  occasion  wrote  that  the  Irish  famine  was  a  ‘mechanism  for  reducing  surplus  population.’  This  was  laissez-­‐faire  taken  to  its  extreme,  but  it  highlighted  the  dominant  belief  the  government’s  role  must  be  strictly  limited  in  the  economy.  

2.  Free  Trade  debate.    

During  the  Nineteenth  Century  there  was  a  big  debate  between  those  who  wanted  free  trade  and  those  who  wanted  tariffs  (often  called  mercantilism).  

The  landed  aristocracy  had  a  vested  interest  in  tariffs  on  imports  of  corn  because  this  kept  the  market  price  of  corn  high  and  therefore  they  could  make  higher  profits.  The  Corn  Laws  restricted  cheap  imports  of  corn  from  1815  to  1846.  

However,  the  Corn  Laws  were  bad  news  for  the  poor,  working  class  who  had  to  pay  more  for  food.  In  the  Nineteenth  Century,  living  standards  of  the  working  class  were  so  poor  that  the  price  of  corn  could  make  the  difference  between  being  able  to  buy  enough  food  to  live  on  and  going  hungry.  

In  1846,  the  Corn  Laws  (tariffs  on  imports  of  corn)  were  repealed,  leading  to  lower  prices  of  food.  Business  owners  generally  supported  the  repeal  of  the  Corn  Laws  because  cheaper  food  was  effectively  a  wage  increase  for  their  workers.  The  repeal  of  the  corn  laws  was  important  for  showing  a  shift  in  balance  of  power  between  the  landed  aristocracy  (who  benefitted  from  high  agricultural  prices)  and  ‘new  money’  –  Industrial  owners  who  benefitted  from  cheaper  living  costs  for  their  workers.  

3.  Growth  of  Capitalism.  

The  Nineteenth  Century  witnessed  rapid  economic  expansion,  helped  by  the  new  railways  and  the  process  of  industrialisation.  Output  increased  at  a  previously  unheard  of  rate.  

4.  Growth  of  the  Banking  Sector.    

The  demands  of  capitalism  led  to  a  growth  in  the  banking  sector  because  there  were  greater  demands  for  raising  finance.  There  were  quite  a  few  spectacular  booms  and  busts,  such  as  the  Railway  mania  of  the  1840s.  

Investors  were  encouraged  to  invest  in  a  variety  of  railway  schemes  on  the  promise  of  big  dividends,  but  these  schemes  were  often  over-­‐optimistic  and  investors  lost  everything.  However,  the  growth  of  a  new  industry  like  the  railways  was  important  in  the  development  of  modern  banking  (and  the  stock  market)  because  there  was  much  greater  demand  for  finance,  which  banks  and  the  stock  market  could  provide.  

5.  First  Government  Regulations.    

The  growth  of  Capitalism,  led  the  government  to  grudgingly,  unwillingly  and  hesitantly  accept  the  necessity  for  some  basic  laws  and  regulations.  Conditions  in  factories  were  often  so  bad  that  campaigns  were  mounted  and  some  laws  were  introduced  to  protect  workers.  There  was  a  growing  realisation  that  the  free  market  did  need  a  degree  of  regulation  and  state  intervention.  

2.  Liberal  Capitalism  1900-­‐1914  

The  election  of  the  Liberals  in  1901  marked  the  start  of  a  new  approach  to  Capitalism.  Faced  with  the  growth  of  trades  unions  and  an  increasingly  organised  working  class,  the  government  responded  by  introducing  the  first  signs  of  a  Welfare  State.  In  the  ‘People’s  Budget’  of  1909,  the  Chancellor  Lloyd  George  (with  strong  support  from  Winston  Churchill)  introduced  the  first  pension  (for  people  over  65)  and  the  first  type  of  unemployment  insurance.    It  was  partly  financed  by  higher  income  tax  on  the  rich.  

The  Welfare  State  was  still  patchy,  but  the  principle  of  government  aid  to  less  fortunate  members  of  society  was  established.  At  the  time,  the  idea  of  redistributing  wealth  was  quite  controversial.  Lloyd  George  said  in  his  speech  to  the  House  of  Commons.  

“This  is  a  war  Budget.  It  is  for  raising  money  to  wage  implacable  warfare  against  poverty  and  squalidness…”  

The  radical  nature  of  the  budget,  led  the  House  of  Lords  to  oppose  it.  This  precipitated  a  constitutional  crisis,  with  the  House  of  Commons  eventually  asserting  its  political  supremacy  over  the  Lords  to  get  the  bill  passed.  

3.  First  World  War  

One  consequence  of  the  First  World  War  was  a  huge  growth  in  the  size  of  government  intervention  in  the  economy.  During  the  war,  the  government  increasingly  micro-­‐managed  every  aspect  of  the  economy.  Government  spending  increased  drastically,  leaving  the  UK  with  a  huge  public  sector  debt  of  over  180%  of  GDP  (more  than  double  todays  debt)  At  the  end  of  the  First  World  War,  women  had  become  involved  in  the  economy  in  a  way  never  previously  known.  

Also,  after  the  end  of  the  First  World  War,  there  was  a  rapid  growth  in  trade  unions  and  the  power  of  organised  Labour.  This  was  illustrated  by  the  Labour  party  gaining  their  first  taste  of  political  power  in  the  short-­‐lived  1924  coalition.  

4.  Gold  Standard  in  the  1920s  

Paris  and  New  York  may  have  been  thriving  during  the  Jazz  age  of  the  1920s,  but  for  the  UK,  the  1920s  was  a  period  of  high  unemployment,  slow  growth  and  steady  decline  in  the  relative  size  of  Britain’s  economy.  

A  key  issue  was  the  government’s  decision  to  re-­‐join  the  gold  standard  and  fix  the  price  of  Pound  to  $4.  The  gold  standard  meant  the  value  of  Pound  Sterling  was  fixed.  However,  the  UK’s  economy  struggled  with  this  high  exchange  rate.  After  the  war,  UK  manufacturing  became  increasingly  uncompetitive,  leading  to  lower  demand  for  exports  and  unemployment.  The  sluggish  growth  led  to  a  prolonged  period  of  deflation  (falling  prices).  This  deflation,  led  to  even  lower  spending  and  rising  debt  burden  harming  economic  growth.  

5.  1930s  Great  Depression  

Already  facing  high  unemployment,  the  UK  economy  was  swept  up  in  the  events  of  the  stock  market  crash  of  1929  and  the  subsequent  Great  Depression.  The  UK  was  a  relatively  open  economy,  relying  on  exports  for  a  considerable  part  of  the  economy.  The  global  slowdown  led  to  a  fall  in  exports,  leading  to  lower  growth  and  higher  unemployment.  This  led  to  a  negative  multiplier  effect,  with  the  unemployed  spending  less  and  leading  to  even  higher  unemployment.  

1931  Budget  By  1931,  the  UK  economy  was  in  a  serious  recession,  unemployment  had  reached  close  to  15%,  and  as  a  consequence  government  borrowing  had  increased.  The  Treasury  economists  told  the  Labour  government,  they  must  balance  the  budget  by  increasing  taxes  and  cutting  spending.  The  Labour  Prime  Minister,  Ramsay  McDonald  agreed  to  these  policies,  but  most  Labour  MPs  didn’t  accept  the  budget,  McDonald  formed  a  National  government,  composed  mostly  of  Conservative  MPs.  

The  spending  cuts  and  higher  taxes,  combined  with  a  fall  in  global  trade  made  the  recession  worse.  It  led  to  a  prolonged  period  of  high  unemployment,  especially  in  the  north  and  industrial  areas.  

It  was  in  the  1930s,  that  J.M.  Keynes  wrote  his  general  theory  of  money  and  argued  for  increased  government  borrowing  and  spending  to  boost  economic  activity.  However,  in  the  1930s,  his  ideas  were  largely  ignored  and  the  UK  remained  stuck  in  recession  with  high  unemployment.  From  1936,  the  UK  economy  did  recover  to  some  extent.  Leaving  the  gold  standard  in  1931  helped,  and  there  was  something  of  a  boom  in  house  building  in  the  late  1930s,  especially  in  the  new  suburbs  of  the  South  East;  but  the  mass  unemployment  remained  until  the  outbreak  of  the  Second  World  War.  

6.  1945-­‐  1970s  Post  War  Prosperity  

In  1945,  the  UK  had  triumphed  in  its  war  aims,  but  the  economy  was  broke.  In  the  post  war  period,  public  sector  debt  stood  reached  over  200%  of  GDP,  and  there  was  a  necessity  for  rationing  to  remain.    

Welfare  State  

Despite  the  record  debt  levels,  the  1945  Labour  government  still  managed  to  set  up  the  basic  framework  of  the  Welfare  State.  The  NHS  and  a  comprehensive  system  of  social  security  was  quite  an  achievement  given  the  perilous  state  of  the  nations  finances.  

During  the  War,  a  liberal  politician  William  Beveridge  had  outlined  a  manifesto  for  eliminating  want  and  poverty.  This  included  a  Welfare  State  and  commitment  to  full  employment.  This  Beveridge  Report  captured  the  imagination  of  the  public  and  was  a  factor  in  helping  Labour’s  shock  election  victory  in  1945.  

Nationalisation.  

In  the  1940s,  the  government  nationalised  many  key  industries.  Some  of  these  like  the  railways  were  broke  anyway;  government  nationalisation  was  necessary  to  keep  them  going.  But,  other  industries  were  nationalised  due  to  ideology  -­‐  the  idea  that  key  industries  should  be  managed  in  the  public  interest  rather  than  purely  for  profit.  

Post  War  Boom.    

Like  other  European  economies,  the  UK  benefited  from  a  prolonged  period  of  economic  expansion.  In  the  post-­‐war  era,  there  was  a  period  of  full  employment,  strong  economic  growth  and  rising  living  standards.  Also,  it  was  a  period  of  rapidly  falling  inequality.  For  the  first  time  the  benefits  of  capitalism  were  being  equally  shared.  Compared  to  other  developed  economies,  the  UK  lagged  behind;  our  growth  and  productivity  were  less  than  our  competitors.  This  was  reflected  in  a  depreciation  in  the  value  of  the  pound.  But,  given  the  overall  rise  in  living  standards,  a  relative  decline  didn’t  seem  so  important.  

7.  1970s  Economic  Instability  

Up  until  the  1970s,  the  UK  had  avoided  both  high  inflation  and  high  unemployment.  Full  employment  and  rising  GDP  were  key  factors  in  keeping  the  welfare  state  affordable.  The  welfare  state  was  so  popular,  it  was  largely  accepted  by  the  Conservatives.  Even  the  nationalisation  of  key  industries  was  generally  accepted.  There  appeared  to  be  a  new  post-­‐war  consensus  based  around  a  mixed  economy,  welfare  state  and  commitment  to  full  employment.  

The  oil  price  shock  of  1973  was  a  serious  blow  to  this  post-­‐war  consensus.  Although  the  UK  was  less  dependent  on  oil  imports  than  other  economies,  the  tripling  of  oil  prices  caused  a  sharp  rise  in  inflation.  Combined  with  powerful  trades  unions  bargaining  for  higher  wages  to  compensate,  the  UK  experienced  a  volatile  and  higher  inflation  rate.  In  1974,  partly  as  a  result  of  the  oil  price  shock,  the  UK  plunged  into  its  first  real  recession  since  the  Great  Depression.  The  recession  was  relatively  short  lived,  but  it  didn’t  solve  the  underlying  inflationary  problems.  There  was  also  concern  over  the  state  of  UK  industry;  a  record  number  of  hours  were  lost  to  strikes.  There  was  a  real  feeling  of  deep-­‐seated  confrontation  between  workers  and  employers.  Key  UK  industries  like  British  Leyland  became  the  butt  of  jokes  for  their  poor  reliability.  The  government  felt  compelled  to  subsidise  industries  like  British  Leyland  to  keep  it  from  going  bankrupt.  But,  government  subsidies  seemed  to  do  nothing  to  improve  productivity  and  change  its  fortunes.  

8.  The  1980s  –  The  Thatcher  Revolution    

In  1979,  the  UK  had  persistently  high  inflation,  poor  productivity  growth,  confrontational  trade  unions  and  a  weak  economy.  But,  few  could  have  predicted  how  radically  the  incoming  Conservative  party,  headed  by  Mrs  Thatcher,  would  change  the  economy.  Key  elements  of  Thatcherite  economics  included:  

Monetarism.  

A  key  tenant  of  Mrs  Thatcher’s  early  economic  policy  was  to  control  inflation.  To  monetarism,  the  control  of  inflation  through  controlling  the  money  supply  was  the  key  to  long-­‐term  sustainable  growth.  Monetarism  witnessed  renewed  interest  in  the  1970s,  helped  by  Milton  Friedman  and  the  apparent  breakdown  of  the  post  war  Keynesian  consensus.  Also,  the  Monetarist  ideology  of  less  government  intervention  appealed  to  politicians  like  Reagan  and  Thatcher.  

In  1980,  Monetarist  policies  in  the  UK  saw  a  rapid  increase  in  interest  rates,  higher  taxes,  and  lower  government  spending.  This  led  to  a  fall  in  inflation  and  negative  economic  growth.  Due  to  the  discovery  of  more  oil  in  the  North  Sea,  there  was  also  a  rapid  appreciation  in  the  value  of  Sterling  during  1979-­‐1980.  The  Pound  surged  in  value,  but  this  made  UK  exports  less  competitive.  The  impact  of  these  policies  on  UK  manufacturers  was  devastating.  There  was  a  deep  recession,  especially  in  the  manufacturing  heartlands.  This  led  to  unemployment  rising  to  3  million  –  a  level  not  seen  since  the  great  depression.  

U-­‐Turn  if  you  want  to  In  October  1980,  as  the  recession  began  to  bite  and  under  great  political  pressure,  Mrs  Thatcher,  stood  up  at  the  Conservative  party  conference,  and  said  ‘You  turn  if  you  want  to.  The  lady's  not  for  turning.’  The  conference  loved  it;  it  was  excellent  politics,  though  the  economic  reality  was  that  unemployment  would  continue  to  increase  and  would  remain  close  to  3  million  until  1985-­‐86.  

In  1981  recession,  365  economists  wrote  a  letter  to  the  Times,  saying  the  government  should  change  its  policy  and  try  and  stem  the  rise  in  unemployment.  But,  economic  policy  didn’t  change.  The  government  made  it  clear  that  it  considered  the  control  of  inflation  to  be  a  higher  priority  than  achieving  full  employment.  Eventually,  the  economy  did  recover  with  low  inflation,  but  it  was  at  a  high  social  cost  of  rising  youth  unemployment  –  a  contributory  factor  to  social  unrest  and  riots,  which  marked  UK  inner  cities  in  1981.  

Miner’s  Strike  1984  In  1974,  the  coal  miners  strike  arguably  helped  defeat  Ted  Heath’s  government.  In  the  1970s,  mining  unions  had  reduced  the  UK  to  a  three-­‐day  week.  To  Mrs  Thatcher  there  was  unfinished  business;  she  wanted  to  tackle  the  power  of  trades  unions  for  once  and  for  all.  She  didn’t  see  why  the  country  should  be  held  to  ransom  by  a  ‘Communist’  such  as  Arthur  Scargill.  After  an  exceptionally  bitter  one-­‐year  strike,  the  government  effectively  won.  It  marked  a  turning  point  in  UK  industrial  relations.    Trades  unions  were  fundamentally  weakened  by  both  the  economic  and  political  changes  of  the  1980s.  Organised  labour  has  never  returned  to  the  levels  of  influence  they  had  in  the  1970s.  

Privatisation  During  the  1980s,  many  nationalised  industries  were  privatised.    These  industries  included  BP,  British  Telecom,  Water,  and  Electricity.  They  were  sold  by  floating  the  new  company  on  the  stock  market.  Many  people  benefitted  from  buying  shares  at  a  discounted  price  and  selling  them  at  a  higher  price.  To  critics,  privatisation  was  a  cynical  political  exercise  to  buy  short-­‐term  popularity  by  selling  key  industries  at  a  lower  cost  than  they  were  worth.  To  supporters,  privatisation  was  a  necessary  policy  to  make  nationalised  giants  face  the  rigours  of  the  free  market.  Defenders  of  privatisation  argue  that  in  the  private  sector,  firms  had  much  greater  incentive  to  be  efficient,  cut  costs  and  be  more  productive.    

The  reality  was  probably  a  mixture  of  the  two.  The  privatised  industries  were  sold  cheaply,  but  after  privatisation  some  industries  did  show  gains  in  productivity  and  efficiency.  However,  some  industries,  such  as  railways,  were  much  more  difficult  to  privatise  and  arguably  led  to  higher  prices  for  consumers,  with  limited  gains  in  service  quality.  

Inequality  One  feature  of  the  1980s  was  a  rapid  rise  in  inequality.  This  was  partly  due  to  the  rise  in  unemployment,  and  also  the  growth  in  wage  inequality.  The  decline  of  manufacturing  led  to  the  loss  of  many  relatively  high  paid  unskilled  jobs.  But,  in  the  service  /  financial  sector,  wages  soared.      

The  Gini  Coefficient  is  a  measure  of  inequality.    A  higher  number  shows  increased  inequality.  

Lawson  Boom  In  the  late  1980s,  the  UK  economy  grew  at  a  record  level.  After  lagging  behind  our  international  rivals  for  most  of  the  post-­‐war  period,  in  the  late  1980s,  the  UK  economy  expanded  at  one  of  the  fastest  rates  in  the  world.  The  government  claimed  vindication  for  its  supply  side  policies  which  they  claimed  had  revitalised  a  moribund  economy.  The  government  argued  that,  freed  from  the  shackles  of  nationalisation,  powerful  unions  and  support  for  inefficient  state  owned  industries,  the  UK  economy  could  grow  at  an  unprecedented  rate.  

The  second  half  of  the  1980s  was  a  period  of  tremendous  enthusiasm  and  confidence.  House  prices  rose  at  record  levels,  reaching  an  annual  growth  rate  of  over  35%.  Even  a  25%  stock  market  crash  in  1987  failed  to  derail  the  economy.  

However,  hopes  of  an  increase  in  the  long  run  average  growth  rate  proved  unfounded.  The  growth  was  too  fast  and  inflationary  pressures  started  to  increase,  reaching  close  to  10%  by  1989.  Rather  belatedly,  the  government  realised  inflation  was  starting  to  become  out  of  control.  To  try  and  control  inflation,  the  chancellor,  Nigel  Lawson,  persuaded  the  government  to  enter  the  exchange  rate  mechanism  (ERM)  a  policy  of  fixing  value  of  pound  to  DM  (a  precursor  to  the  Euro)  Joining  the  ERM  necessitated  higher  interest  rates  to  keep  the  value  of  the  pound  at  its  target  level  and  to  reduce  inflation.  

Source:  of  base  rate  Bank  of  England  series  IUMAAMIH  

However,  the  drastic  increase  in  interest  rates  proved  to  be  devastating  for  homeowners  who  struggled  with  their  mortgage  payments,  which  now  shot  through  the  roof.  As  interest  rates  increased,  house  prices  fell.  This  combination  of  higher  interest  rates  and  falling  house  prices  caused  the  recession  of  1990-­‐01.  Unemployment  once  again  rose  to  3  million.  

Despite  the  depth  of  the  recession,  the  government  were  committed  to  keeping  the  Pound  in  the  ERM.  However,  to  keep  the  Pound  at  its  target  level  against  the  D-­‐Mark,  interest  rates  had  to  be  kept  very  high.  This  strangled  any  hope  of  recovery.  Market  investors  felt  the  government  were  making  a  mistake  and  it  wasn’t  possible  to  keep  the  Pound  at  such  a  high  level  –  given  the  state  of  the  economy.  Investors  sold  Sterling,  and  the  government  used  its  foreign  exchange  reserves  to  buy  Sterling  to  try  and  protect  the  value  of  the  currency.  However,  on  Black  Thursday,  October  1992,  the  government  finally  admitted  defeat  and  left  the  ERM.  However,  by  leaving  the  ERM,  interest  rates  were  reduced  and  the  economy  could  recover.  

9.  1993-­‐2007  The  Great  Moderation  

After  this  boom  and  bust,  the  government  tried  to  prevent  future  inflationary  boom  and  busts.  An  important  change  was  that  The  Bank  of  England  were  given  independence  to  set  interest  rates;  they  were  instructed  to  target  an  inflation  rate  of  2.5%  (now  CPI  2%).  The  idea  was  that  the  Bank  of  England  would  avoid  the  political  pressure  to  cut  rates  before  an  election.    It  was  also  hoped  that  an  independent  Central  Bank  would  have  greater  credibility  in  keeping  inflation  low.  

After  the  1992  recession,  the  UK  experienced  the  longest  period  of  economic  expansion  on  record.  Yet,  despite  the  prolonged  growth  there  was  no  resurgence  in  inflation.  In  fact,  inflation  remained  very  close  to  the  government’s  target  of  2%.  There  were  quite  a  few  who  felt  we  deserved  a  degree  of  self-­‐congratulation  for  breaking  the  boom  and  bust  cycle  and  delivering  sustainable  low-­‐inflationary  growth.  It  did  appear  the  Bank  had  been  able  to  prevent  inflationary  booms,  which  the  UK  had  seemed  so  susceptible  to  in  the  past.  

Yet,  behind  this  ‘great  moderation’  was  a  different  type  of  boom  and  bust,  which  was  largely  ignored  or  given  little  attention.  This  was  a  different  kind  of  boom.  It  was  a  boom  in  bank  lending  and  rise  in  asset  prices.  It  was  a  period  where  banks  took  on  more  lending  and  more  risk.  But,  these  levels  of  lending  later  proved  to  be  unsustainable.      

In  the  1980s,  many  building  societies  were  de-­‐mutualised  and  become  private  banks  listed  on  the  stock  market.  This  changed  their  behaviour  -­‐  the  new  banks  sought  to  make  ever-­‐greater  profits;  former  building  societies  like  Northern  Rock  and  Bradford  &  Bingley  became  among  the  fastest  growing  lenders.    To  

lend  more  mortgages,  they  would  borrow  money  on  money  markets.  Effectively  they  were  borrowing  money  at  a  low  interest  rate  and  lending  this  borrowed  money  at  a  higher  interest  rate.  

This  was  fine  until  the  global  credit  crunch.  Suddenly  banks  could  no  longer  borrow  from  money  markets,  to  finance  their  lending.  This  meant  banks  like  Northern  Rock  suddenly  found  themselves  short  of  liquidity  (cash)  and  ultimately  required  a  bailout  by  the  government.  

The  difference  in  the  past  was  that  building  societies  lent  money  they  attracted  in  savings.  Therefore,  building  societies  were  not  dependent  on  global  money  markets.  But,  in  the  new  era  of  deregulated  banking,  banks  were  also  lending  money  that  they  had  borrowed.  This  enabled  them  to  make  more  profits  in  the  boom  years,  but  it  left  them  exposed  with  big  holes  in  their  balance  sheets  when  they  could  no  longer  borrow.  

Q.  Why  were  banks  so  reckless  in  lending  money  they  didn’t  have?  

It  is  always  easy  to  be  wise  after  the  event.  But,  it  is  worth  trying  to  understand  why  banks  acted  like  they  did.  

1. For  quite  a  few  years,  it  was  profitable.  Banks  felt  they  had  a  duty  to  maximise  profits  for  their  shareholders,  and  increasing  the  quantity  of  lending  was  a  method  to  do  this.  

2. Higher  profit  meant  higher  bonuses.  A  lot  has  been  written  about  bank  bonuses,  not  always  favourably.  But,  if  banks  made  higher  profit,  the  directors  were  often  in  line  to  receive  million  pound  performance  related  pay.  There  was  a  clear  financial  incentive  to  seek  higher  profit.  

3. Belief  in  stability.  In  the  past,  instability  came  from  inflation.  But,  with  inflation  low  and  economic  growth  positive,  there  were  reasons  to  believe  that  we  were  experiencing  a  sustained  period  of  economic  expansion  and  economic  stability.  And,  to  some  extent  we  were,  1993-­‐2008  was  the  longest  period  of  economic  expansion  on  record.  

4. Era  of  low  interest  rates.  With  inflation  seemingly  tamed,  it  enabled  much  lower  long-­‐term  interest  rates  which  made  borrowing  more  attractive.  

5. Belief  in  rising  house  prices.  Although  house  prices  rose  to  record  levels  and  the  ratio  of  house  price  to  incomes  increased,  many  felt  these  levels  were  still  sustainable.  

6. Belief  in  the  free  market.  The  1980s  and  1990s  saw  a  process  of  financial  deregulation.  It  was  felt  that  the  government  were  incapable  of  regulating  the  financial  sector,  and  anyway  it  was  better  to  leave  it  to  the  free  market.  

7. Global  competition.  Globalisation  meant  that  it  seemed  easy  to  attract  capital  from  around  the  world.  Therefore,  it  seemed  that  one  of  the  benefits  of  globalisation  was  different  rules  –  and  an  ability  to  lend  more  than  previously.  

10.  2008  -­‐  12  Recession  

In  2008,  the  UK  entered  recession  because:  

• After  the  credit  crunch,  banks  radically  reduced  lending,  leaving  business  short  of  funds  for  investment.  

• Higher  oil  prices  reducing  living  standards  and  disposable  income  • Falling  house  prices  leading  to  lower  household  wealth  and  lower  

spending.  • Fall  in  exports  due  to  global  economic  downturn.  • Fall  in  confidence  over  bad  economic  news.  • Rise  in  saving  ratio  as  people  tried  to  pay  off  debts.  

Because  of  the  depth  of  the  fall  in  GDP,  interest  rates  were  slashed  to  0.5%  by  March  2009.  This  was  a  record  low,  but  even  these  record  low  interest  rates  failed  to  bring  about  a  quick  economic  recovery.    

This  was  a  different  recession  to  1981  and  1991.  In  the  previous  recessions,  the  fall  in  demand  had  been  caused  by  a  rise  in  interest  rates  or  rise  in  value  of  pound.  When  these  were  reversed,  the  economy  could  recover.  

But,  in  2008-­‐11,  the  recession  was  caused  by  fundamental  problems  in  the  banking  sector.  Cutting  interest  rates  couldn’t  reverse  the  fall  in  demand.  

• The  whole  banking  sector  was  short  of  liquidity  and  so  didn’t  want  to  lend.  

• Lower  base  rates  didn’t  really  help  because  banks  were  unwilling  to  lend,  even  if  people  wanted  to  borrow.  

Why  Did  the  Recession  of  2008-­‐12  Last  So  Long?  

1.  Debt  Deleveraging.  In  2008,  total  UK  private  sector  debt  was  high.  After  the  credit  crunch  banks  and  individuals  sought  to  reduce  their  debt  burdens  by  cutting  bank  on  bank  lending  and  spending  less.  But,  to  reduce  debt  burdens  can  be  a  long  process.  In  2012,  the  UK  still  had  one  of  the  highest  combined  debt  levels  (public  debt  +  private  debt)  of  400%  of  GDP  (McKinsey  report  on  Debt  deleveraging,  Jan  2012)  

2.  Declining  Living  Standards.  Despite  the  fall  in  economic  output,  we  also  experienced  inflation.  This  inflation  was  due  to  cost-­‐push  factors  such  as:  

• Impact  of  devaluation  increasing  the  price  of  imports.  • Rise  in  price  of  petrol,  food,  energy  and  other  commodities  • Rise  in  taxes  (e.g.  VAT  increase)  

Therefore,  with  a  decline  in  real  incomes,  it  is  inevitable  consumer  spending  was  reduced.  

3.  Government  Austerity.  There  was  a  partial  economic  recovery  in  2010.  However,  after  being  elected  the  Conservative  /  Lib  Dem  coalition  made  plans  to  reduce  the  size  of  the  UK’s  budget  deficit.  They  claimed  that  the  Euro  debt  crisis  meant  it  was  necessary  to  reduce  government  borrowing  quickly,  therefore  the  government  cut  spending  and  increased  taxes.  Whether  it  was  necessary  to  act  so  quickly  or  not  is  uncertain.  But,  the  attempts  to  reduce  government  borrowing  led  to  lower  aggregate  demand  contributing  to  a  double  dip  recession  in  2011-­‐12.  

4.  Lower  Interest  Rates  Didn’t  Work.  Usually  interest  rates  of  0.5%  would  boost  spending  investment  and  encourage  people  to  buy  a  house.  But,  in  the  recession  of  2008-­‐12,  banks  didn’t  want  to  lend  at  these  low  interest  rates.  Therefore,  even  though  it  was  theoretically  cheap  to  borrow,  in  practise  it  was  difficult.  

5.  UK  Badly  Hit  by  Decline  in  Financial  Services.  The  recession  directly  affected  the  financial  service  sector.  This  is  one  of  the  UK’s  most  important  industries  and  a  key  source  of  government  tax  revenue.  Because  of  the  impact  on  financial  services,  the  UK  economy  was  adversely  affected  more  than  others.  

European  Debt  Crisis  

In  2007,  EU  economies,  on  the  surface,  seemed  to  be  doing  relatively  well  –  with  positive  economic  growth  and  low  inflation.  Public  debt  was  often  high,  but  (apart  from  Greece)  it  appeared  to  be  manageable  -­‐  assuming  a  positive  trend  in  economic  growth.  For  example,  in  2007.  

Spain’s  debt  to  GDP  ratio  –  37%      

Ireland’s  debt  to  GDP  ratio  –  27%  

Japan  by  contrast  had  a  debt  to  GDP  ratio  of  220%  of  GDP.  Few  would  have  predicted  that  Europe  would  soon  have  a  debt  crisis.  

However,  the  global  credit  crunch  changed  many  things.  

• Bank  Loses.  During  the  credit  crunch,  many  commercial  European  banks  lost  money  on  their  exposure  to  bad  debts  in  the  US  (e.g.  subprime  mortgage  debt  bundles  which  became  worthless)  

• Recession.  The  credit  crunch  caused  a  fall  in  bank  lending  and  investment;  this  caused  a  serious  recession.  The  recession  led  to  a  fall  in  tax  revenues  and  required  higher  government  spending  on  benefits.  Therefore,  European  governments  saw  a  rapid  rise  in  their  budget  deficits.  

• Fall  in  House  Prices.  The  recession  and  credit  crunch  also  led  to  a  fall  in  European  house  prices,  which  increased  the  losses  of  many  European  banks.  This  was  particularly  damaging  for  a  country  like  Spain  which  had  seen  a  boom  in  house  building  in  the  boom  years.  

Graph  showing  the  scale  of  European  Recession.  

Problems  of  Recession  and  Debt        

The  European  recession  caused  a  rapid  rise  in  government  debt.  The  recession  caused  a  steep  deterioration  in  government  finances.  When  there  is  negative  growth,  the  government  receive  less  tax.  

• Fewer  people  working  =  less  income  tax;  fewer  people  spending  =  less  VAT;  smaller  company  profits  =  less  corporation  tax  etc.)  

• The  government  also  have  to  spend  more  on  unemployment  benefits.)  

Also,  as  well  as  falling  tax  revenues,  falling  GDP  means  the  debt  to  GDP  ratio  will  rise  more  rapidly.  

• For  example,  between,  2007  and  2011,  UK  public  sector  debt  almost  doubled  from  36%  of  GDP  to  62%  of  GDP.  

• Between  2007  and  2010,  Irish  government  debt  rose  from  27%  of  GDP  to  over  90%  of  GDP.  

EU  Bond  Yields  

During  the  early  2000s,  markets  had  assumed  Eurozone  debt  was  safe.  Investors  assumed  that  with  the  backing  of  all  Eurozone  members  there  was  an  implicit  guarantee  that  all  Eurozone  debt  would  be  safe  and  therefore  there  was  no  risk  of  default.  Therefore,  investors  were  willing  to  hold  Eurozone  debt  at  low  interest  rates  even  though  some  countries  had  quite  high  debt  levels  (e.g.  Greece,  Italy).  In  a  way,  this  perhaps  discouraged  countries  like  Greece  from  tackling  their  debt  levels.  (They  were  lulled  into  false  sense  of  security  by  low  interest  rates)  

However,  after  the  credit  crunch,  investors  became  more  sceptical  and  started  to  question  European  finances.  Looking  at  Greece,  they  felt  the  size  of  public  sector  debt  was  too  high  given  the  state  of  the  economy.  People  started  to  sell  Greek  bonds,  which  pushed  up  interest  rates.  

Unfortunately,  the  EU  had  no  effective  strategy  to  deal  with  this  sudden  panic  over  debt  levels.  It  became  clear  the  German  taxpayer  wasn’t  so  keen  on  underwriting  Greek  bonds.  There  was  no  fiscal  union  and  investors  realised  that  Eurozone  countries  could  actually  default.  It  was  very  difficult  for  the  EU  to  agree  on  any  comprehensive  debt  bailout.    There  was  a  real  risk  of  debt  default.  Therefore,  markets  started  selling  more  –  leading  to  higher  bond  yields.  

No  Lender  of  Last  Resort.    

Usually,  when  investors  are  reluctant  to  buy  bonds  and  it  becomes  difficult  to  ‘roll  over  debt’  –  the  Central  bank  of  that  country  intervenes  to  buy  government  bonds.  This  can  reassure  markets,  prevent  liquidity  shortages,  keep  bond  rates  low  and  avoid  panic.  But,  the  ECB  made  it  very  clear  to  markets  it  will  not  do  this.  Countries  in  the  Eurozone  have  no  real  lender  of  last  resort.  Markets  really  dislike  this  as  it  increases  the  chance  of  a  liquidity  crisis  becoming  an  actual  default.  

               For  example,  UK  debt  rose  faster  than  many  Eurozone  economies,  yet  there  has  been  no  rise  in  UK  bonds  yields.  One  reasons  investors  are  currently  willing  to  hold  UK  bonds  is  that  they  know  the  Bank  of  England  will  intervene  and  buy  bonds  if  necessary.  

Contagion  

After  Greece  saw  rapid  rises  in  bond  yields,  investors  began  to  examine  all  countries  in  the  Eurozone.  There  was  a  knock  on  effect  with  investors  becoming  generally  more  sceptical  about  Eurozone  debt.  All  countries  in  Eurozone  became  much  more  closely  scrutinised.  Quite  quickly  many  European  countries  saw  a  rapid  increase  in  bond  yields  –  Ireland,  Portugal,  Italy,  and  Spain.  

Un-­‐Competitiveness  in  the  Euro.  

Eurozone  countries  with  debt  problems  are  also  generally  uncompetitive  with  a  higher  inflation  rate  and  higher  labour  costs.  This  means  there  is  less  demand  for  their  exports.  This  decline  in  demand  for  exports  leads  to  lower  economic  growth.  Because  they  are  uncompetitive  this  leads  to  a  large  current  account  deficit  and  lower  economic  growth.  (The  UK  became  uncompetitive,  but  being  outside  the  Euro,  the  Pound  could  depreciate  20%  in  2009  restoring  competitiveness.    In  the  Euro,  countries  can’t  devalue  to  restore  competitiveness.  Thus,  they  face  a  continued  decline  in  domestic  demand.  

Poor  Prospects  for  Growth  

People  have  been  selling  Greek  and  Italian  bonds  for  two  reasons.  Firstly,  because  of  high  structural  debt;  but,  also  because  of  very  poor  prospects  for  economic  growth.  Countries  facing  debt  crisis  have  to  cut  spending  and  implement  austerity  budgets.  This  causes  lower  growth,  higher  unemployment  and  lower  tax  revenues.  However,  countries  with  debt  crisis  have  nothing  to  stimulate  economic  growth.  

• They  can’t  devalue  the  exchange  rate  to  boost  competitiveness  (they  are  in  the  Euro)  

• They  can’t  pursue  expansionary  monetary  policy  (ECB  won’t  pursue  quantitative  easing,  and  actually  increased  interest  rates  in  2011  because  of  inflation  in  Germany)  

• They  are  only  left  with  internal  devaluation  (trying  to  restore  competitiveness  through  lower  wages,  increased  competitiveness  and  supply  side  reforms.  But,  this  process  of  internal  devaluation  can  take  years  of  high  unemployment  and  low  growth.  

Paradox  of  Austerity  and  Higher  Bond  Yields.  

It  is  a  paradox  that  markets  see  high  debt  levels  and  call  for  spending  cuts.  These  temporary  spending  cuts  please  the  market,  but  as  a  result  of  spending  cuts,  the  economy  goes  into  recession  leading  to  lower  tax  revenues  and  higher  debt.  This  makes  it  difficult  to  reduce  debt  to  GDP  (and  also  leads  to  calls  for  more  austerity).  Olivier  Blanchard  of  IMF  writes:  

They  react  positively  to  news  of  fiscal  consolidation,  but  then  react  negatively  later,  when  consolidation  leads  to  lower  growth—which  it  often  does.  (2011  in  Review:  Four  Hard  Truths)  

Individual  Cases  

Ireland  

Ireland’s  debt  crisis  was  mainly  because  the  Irish  Government  had  to  bailout  their  own  banks.  The  bank  losses  were  massive  and  the  Irish  government  needed  to  inject  billions  into  the  commercial  banks.  However,  combined  with  a  collapse  in  tax  revenues  from  the  recession,  Irish  government  debt  rose  too  quickly.  The  Irish  government  then  needed  a  bailout.  (In  a  way  it  was  a  bailout  to  pay  for  the  bank  bailout)      

Greece  

Greece  had  a  very  large  debt  problem  even  before  joining  Euro  and  before  the  credit  crisis.  The  credit  crisis  exacerbated  an  already  significant  problem.  The  Greek  economy  was  also  fundamentally  uncompetitive  –  reflected  in  a  large  current  account  deficit  and  low  growth.  Attempts  to  reduce  the  budget  deficit  led  to  a  significant  fall  in  output  and  even  lower  tax  revenues.  

Italy  

Italy’s  debt  crisis  was  due  to  a  combination  of  long-­‐term  structural  problems,  such  as  failure  to  collect  tax  revenues.  Italy  also  had  very  weak  growth  prospects  and  a  legacy  of  political  instability.  

Summary  of  Main  Causes  of  Debt  Crisis  

• High  structural  debt  before  crisis.  Exacerbated  by  ageing  population  in  many  European  countries.  

• Recession  causing  sharp  rising  in  budget  deficit.  • Credit  crunch  caused  losses  for  commercial  banks.  Therefore,  after  credit  

crunch,  investors  became  much  more  cautious  and  fearful  of  default  in  all  types  of  debt.  

• Southern  European  economies  were  uncompetitive  (higher  labour  costs)  but  couldn’t  devalue  to  restore  competitiveness.  This  causes  lower  growth  and  lower  tax  revenues  in  these  countries.  

• No  lender  of  last  resort  (like  in  UK  and  US)  makes  markets  nervous  of  holding  Eurozone  debt  because  they  can  easily  experience  liquidity  crisis.  

• No  effective  bailout  for  a  country  like  Italy.  • Fears  of  default  raise  bond  yields,  but  this  makes  it  much  more  expensive  

to  pay  interest  on  debt,  e.g.  cost  of  servicing  Italian  debt  has  risen  meaning  they  will  have  to  raise  €650bn  ($880bn)  over  next  three  years.  It  becomes  a  vicious  spiral.  Higher  debt  leads  to  higher  interest  rate  costs  making  it  more  difficult  to  repay.  

• It’s  very  difficult  to  leave  the  Euro.  • Unfortunately,  the  solutions  to  the  debt  crisis  have  often  been  self-­‐

defeating.  For  example,  faced  with  large  budget  deficit  and  rising  bond  yields,  countries  have  pursued  ‘fiscal  austerity’  –  spending  cuts  and  higher  taxes.  However,  this  causes  lower  growth.  The  lower  economic  growth  creates  a  negative  spiral  of  falling  tax  revenues,  higher  unemployment  and  higher  borrowing.  

• The  solution  to  the  Euro  debt  crisis  requires  more  than  just  spending  cuts.  It  also  requires:    1. Policies  to  increase  economic  growth  and  reduce  unemployment  2. Policies  to  restore  competitiveness  due  to  overvalued  exchange  rates  

Why  do  Economists  Disagree  so  often?  

Economics  tries  to  deal  with  facts,  but  there  can  be  many  different  interpretations  of  the  same  data.  Firstly,  economists  do  agree  over  many  things,  but  there  can  also  be  severe  disagreement  even  amongst  Nobel-­‐prize  winning  economists.  

Examples  of  Disagreement  

1.  Importance  of  Low  Inflation  

Let  us  take  the  example  of  CPI  inflation  rising  to  4.5%  in  2011  (above  the  governments  target  of  2%)  During  this  period,  unemployment  was  high  and  economic  growth  low.  

In  general  economists  will  all  agree  that:  

• CPI  Inflation  is  4.5%  • Inflation  is  potentially  damaging  to  the  economy  • Monetary  Policy  (interest  rates)  should  generally  be  used  to  keep  

inflation  low  

However,  there  were  two  different  suggestions  on  what  to  do  next.  

1. Increase  Interest  Rates.  Inflation  is  well  above  target;  therefore  the  Central  Bank  should  increase  interest  rates  to  keep  inflation  on  target.  If  the  Bank  doesn’t  increase  interest  rates  then  they  will  lose  credibility  for  keeping  inflation  low.  Also  if  they  allow  inflation  to  persist  it  will  lead  to  higher  inflation  expectations  in  the  future,  and  this  cost-­‐push  inflation  can  become  permanent.    

2. Keep  Interest  rates  low.  Although  inflation  is  above  target,  it  is  actually  due  to  temporary  factors  (rising  oil  prices,  rising  taxes).  Therefore,  the  Bank  shouldn’t  increase  interest  rates  because  core  ‘underlying’  inflation  is  actually  low.  Also  if  they  increase  interest  rates  it  could  push  the  economy  back  into  recession.  Therefore,  although  inflation  is  above  target,  it  is  more  important  to  worry  about  unemployment  and  economic  growth.  

Both  points  of  view  offer  reasonable  economic  analysis.  The  difference  stems  from:  

• Which  is  more  important  low  inflation  or  low  unemployment?  • Is  the  inflation  permanent  or  temporary?  • Will  this  temporary  inflation  increase  future  inflation  expectations?  

In  2011,  the  ECB  increased  interest  rates  in  response  to  the  cost  push  inflation.    By  contrast,  the  Bank  of  England  kept  interest  rates  at  0.5%  -­‐  despite  inflation  in  the  UK  being  much  higher.  This  shows  how  Central  Banks  can  take  different  responses  to  the  same  situation.  

2 Do  Tax  Cuts  Increase  Tax  Revenues?  A  popular  economic  argument  amongst  free  market  economics  is  the  idea  tax  cuts  can  increase  incentives  to  work.  Some  even  suggest  tax  cuts  can  actually  increase  tax  revenue.  

For  example,  if  income  tax  was  set  very  high  at  say  70%,  people  may  feel  no  incentive  to  work.  They  may  even  leave  and  work  in  another  country  with  a  lower  tax  rate.  

Therefore,  if  you  cut  income  tax,  the  argument  is  that  people  will  be  more  willing  to  work.  Therefore  as  more  people  work,  the  government’s  tax  revenue  may  actually  increase,  even  though  the  tax  rate  is  lower.  

There  was  an  economist  called  Laffer.  He  reasoned  that  if  there  was  a  tax  rate  of  100%,  the  government  would  get  no  tax.  If  the  tax  rate  was  0%,  the  government  would  also  get  no  tax.  Therefore,  they  must  be  a  tax  rate  at  which  revenue  is  at  a  peak.  

Therefore,  he  claimed  in  many  cases  a  tax  cut  could  increase  government  revenues.  This  idea  of  cutting  taxes  and  getting  more  revenue  obviously  appealed  to  quite  a  few  politicians!    

However,  the  other  point  of  view  states  in  the  real  world,  a  cut  in  income  tax  is  not  guaranteed  to  make  people  work.    

• Suppose  you  have  a  target  disposable  income  of  £20,000  a  year  which  you  need  to  pay  your  bills  and  buy  everything  you  need.    

• A  cut  in  income  tax  means  it  is  easier  to  earn  this  target  of  £20,000  disposable  income.  You  can  actually  work  less  to  gain  your  target  income.  

• If  income  tax  increases,  the  average  worker  is  unlikely  to  be  able  to  cut  back  on  hours.  They  may  even  feel  they  need  to  work  longer  hours  to  gain  enough  income.  

Whether  High  Tax  rates  reduce  incentives  depends  on  quite  a  few  factors  

Only  the  very  rich  will  tend  to  consider  moving  country  to  avoid  high  rates  of  tax.  The  average  worker  can’t  relocate  to  Jersey  because  income  tax  has  increased  from  21%  to  23%.  But,  for  a  millionaire,  it  may  be  worth  moving.  The  tax  saved  is  greater  than  the  cost  of  relocating.  

Also  it  depends  on  the  rate  of  income  tax.  In  post  war  Britain,  the  highest  income  tax  rate  was  87%.  Clearly  this  was  a  very  dramatic  tax  which  did  make  work  look  unattractive  for  high-­‐income  earners.  At  this  kind  of  rate,  there  is  a  strong  disincentive  to  work.  

But,  if  you  increase  the  higher  income  tax  rate  from  40-­‐50%  it  is  more  uncertain  whether  people  will  reduce  their  hours.    

Arguably,  globalisation  means  that  high  tax  rates  have  a  greater  impact  on  disincentives  than  50  years  ago.    In  the  late  1940s,  it  wasn't  so  practical  to  go  and  live  abroad  to  avoid  paying  taxes.  But,  in  the  Twenty  First  Century,  it  is  much  easier.        

Frequently  asked  Questions  

Some  of  these  questions  have  already  been  answered  in  this  economics  help  guide.  But,  as  they  get  asked  so  frequently,  I’ll  put  them  in  their  own  section  here.  

Q.  Who  Does  the  UK  Owe  Money  To?  

The  UK  government  has  borrowed  from  the  private  sector  by  selling  bonds.  These  are  bought  by  a  variety  of  financial  bodies  such  as  pension  funds,  investment  trusts  and  banks.  Foreign  banks  may  buy  about  25-­‐30%  of  these  bonds.  But,  mostly,  the  government  owe  money  to  individuals  and  bodies  in  the  UK.  

Q.  How  much  do  we  (UK)  Owe?  

When  people  ask  how  much  do  we  owe,  they  usually  mean  how  much  does  the  government  owe?  

The  official  level  of  UK  public  sector  debt  is  just  over  £1,004bn  (start  of  2012)  or  64%  of  GDP.  But,  by  the  time  you  read  this,  it  will  be  higher.  

There  are  other  measures  of  government  debt,  for  example,  if  you  include  liabilities  from  financial  sector  intervention,  UK  public  sector  debt  is  much  higher  at  over  £2,200bn.  However,  the  government  hopes  to  reclaim    a  good  proportion  of  this  financial  sector  intervention  after  selling  shares  in  nationalised  banks.  

We  could  also  look  at  total  UK  debt.  This  includes  private  debt  +  government  debt.    Private  debt  includes  (mortgage  debt,  personal  loans,  credit  card  debt,  corporate  debt).  Total  UK  debt  is  around  400%  of  GDP.  This  is  one  of  highest  levels  in  the  developed  world.  

To  confuse  things  there  is  also  something  known  as  external  debt.  This  is  the  money  we  owe  to  people  in  other  countries.  It  is  mostly  banking  liabilities.  Note,  the  Government  only  contributes  a  small  amount  to  external  debt.  External  debt  is  around  £6,000bn  or  500%  of  GDP.  However,  we  also  have  external  assets  of  around  £6,000bn.  As  long  as  our  assets  (investments  abroad)  don’t  devalue,  it’s  not  quite  as  bad  as  it  sounds.  But,  high  external  debt  can  potentially  cause  problems.  

Q.  Why  does  the  government  borrow  to  try  and  deal  with  the  problems  of  debt?  

It  is  true  bad  debts  did  cause  the  credit  crunch  of  2008,  and  this  led  to  the  recession  of  2009.  However,  in  a  recession,  consumers  often  rapidly  increase  their  savings  causing  a  sharp  fall  in  consumer  spending.  This  leads  to  lower  economic  growth.  Therefore,  the  government  borrow  to  offset  this  rise  in  private  sector  saving.  Through  government  borrowing,  they  aim  to  maintain  aggregate  demand  and  limit  the  fall  in  GDP.  If  the  government  cuts  its  deficit  in  a  recession,  there  would  be  a  fall  in  consumer  spending  and  also  fall  in  government  spending  causing  a  more  significant  fall  in  growth.  

Q.  Why  doesn’t  the  government  subsidise  firms  to  develop  new  technology,  which  improves  the  economic  growth  rate?  

There  may  be  a  case  for  the  government  subsidising  some  technologies  which  have  a  potential  benefit  for  society  and  would  be  underfunded  in  a  free  market.  For  example,  solar  power  energy  could  provide  carbon  free  energy.  Solar  power  has  a  strong  positive  externality  because  it  helps  to  reduce  pollution  and  global  warming.  However,  it  is  important  to  bear  in  mind,  most  technological  improvements  in  an  economy  tend  to  come  from  the  private  sector.  The  government  has  a  poor  track  record  of  picking  technological  winners  (apart  from  in  times  of  war).  There  is  only  a  limited  role  the  government  can  play  in  creating  technological  advances.  However,  if  a  good  has  a  high  positive  externality  (benefit  to  third  party),  then  in  theory  government  subsidy  can  help  to  overcome  the  market  failure  of  under-­‐consumption  in  a  free  market.  

Q.  Does  printing  money  cause  inflation?    

Yes,  printing  money  does  usually  cause  inflation.  Printing  money  leaves  national  output  the  same.  However,  with  more  money  chasing  the  same  number  of  goods.  Firms  will  respond  by  pushing  up  prices.  Let  us  assume  due  to  printing  money  there  is  a  100%  increase  in  the  money  supply.  The  amount  of  cash  people  has  doubles.  However,  the  amount  of  goods  stays  the  same.  In  that  case  the  price  of  these  goods  will  just  increase  100%.  Printing  money  has  not  created  output,  only  caused  things  to  be  more  expensive.  

Monetarist  theory  suggests  there  is  a  strong  link  between  the  money  supply  and  inflation.  If  you  increase  the  money  supply,  prices  will  increase.  

Q.  Can  you  Print  Money  Without  Causing  Inflation?  

Yes,  it  is  possible.  In  a  deep  recession,  this  link  between  printing  money  and  inflation  can  be  broken.  A  short  explanation  is  that  in  a  recession,  banks  and  consumers  may  just  hoard  (save)  this  extra  money.  Therefore,  although  there  is  an  increase  in  notes  and  coins,  the  frequency  with  which  they  change  hands  declines.  

Monetarist  theory  states  inflation  is  linked  to  money  supply  by  this  formula  

MV=PY  (M  –  money  supply.  P=Price  Level,  V=  Velocity  of  circulation,  and  Y  =  output)  

Monetarist  theory  assumes  V  and  Y  are  stable.  But,  in  practise  they  may  not  be.  

If  velocity  of  circulation  falls,  you  may  need  an  increase  in  the  money  supply  to  prevent  prices  falling.  

When  the  Bank  of  England  created  money  through  quantitative  easing.  They  increased  the  money  supply  and  bought  bonds  from  commercial  banks.  Banks  saw  an  increase  in  their  bank  reserves.  Usually,  they  would  lend  this  out  and  this  extra  lending  could  cause  inflation.  But,  in  a  recession,  banks  just  kept  the  money  and  improved  their  balance  sheets.  Therefore,  there  wasn’t  inflation.  

Q.  Could  Printing  Money  Create  Delayed  Inflation?  

In  a  recession,  the  extra  money  is  saved  and  so  inflation  does  not  occur.  However,  over  time,  the  economy  could  recover,  and  the  extra  money  could  cause  inflation  unless  the  Central  Bank  can  adequately  reverse  its  increase  in  the  money  supply.  But,  there  are  no  hard  and  fast  rules.  It  depends  on  many  different  factors.  

Q.  Why  do  Rising  Commodity  prices  create  a  dilemma  for  Monetary  Policy?  

Rising  commodity  prices  increase  inflation,  but  they  also  reduce  disposable  income  leading  to  lower  economic  growth.  

The  Bank  of  England  faces  an  inflation  target  of  2%,  but  they  also  try  to  maintain  strong  economic  growth.  

If  inflation  rises  above  target  (due  to  rising  commodity  prices),  then  the  Bank  will  feel  they  need  to  increase  interest  rates.  But,  on  the  other  hand,  slower  economic  growth  means  they  might  want  to  cut  interest  rates  to  increase  economic  growth.  

It  is  very  difficult  for  the  Bank  of  England  to  tackle  the  twin  problems  of  inflation  and  slower  economic  growth  at  the  same  time.  To  some  extent,  they  have  to  choose  whether  to  accept  higher  inflation  or  lower  economic  growth.  

Q.  Why  does  the  threat  of  a  Credit  Rating  Downgrade  push  up  Government  Bond  Yields?  

A  credit  rating  is  an  evaluation  of  how  reliable  government  borrowing  is.  If  markets  have  perfect  faith  the  government  will  repay  all  its  debt,  they  will  get  an  AAA  credit  rating.  This  means  they  are  safe.  If  people  feel  bonds  are  a  safe  investment,  they  will  accept  a  low  interest  rate  in  return  for  the  safe  investment.  

However,  if  markets  feel  a  government  is  borrowing  too  much,  there  is  a  greater  chance  of  defaulting  on  debt.  Then  they  may  get  a  credit  rating  downgrade  (e.g.  BBB).  This  means  there  is  a  risk  of  default.  

If  you  think  a  government  is  risky,  then  you  will  want  a  higher  interest  rate  on  bonds  to  compensate  for  the  risk  of  losing  your  investment.  

A  credit  rating  downgrade  tends  to  be  bad  news  for  a  government  because  it  means  it  will  be  more  difficult  and  expensive  to  borrow.  

Q.  Why  Do  Manufacturers  complain  about  a  strong  pound?  

A  large  proportion  of  manufacturing  output  is  exported.  A  strong  pound  means  that  the  foreign  price  of  UK  exports  will  be  higher.  This  makes  it  more  expensive  for  foreigners  to  buy  British  goods.  Therefore,  exporters  will  struggle  to  remain  competitive  and  sell  their  exports.  

Q.  Why  Can  Low  Interest  Rates  fail  to  boost  economic  growth?  

In  theory,  low  interest  rates  should  boost  economic  growth.  Lower  interest  rates  make  it  cheaper  to  borrow  and  should  encourage  investment  and  spending.  However,  in  practise,  people  may  not  want  to  spend  and  invest  –  even  though  it  is  cheap  to  borrow.  People  may  have  low  confidence  and  so  continue  to  save.  

This  leads  to  low  growth  and  economic  stagnation.  Also,  interest  rates  may  be  low,  but  if  banks  are  short  of  liquidity,  they  won’t  make  funds  available  for  lending,  i.e.  it  might  be  cheap  to  borrow,  but  the  quantity  is  limited.  

Q.  Is  the  World  Economy  Going  to  Collapse?  

There  have  always  been  people  predicting  the  imminent  collapse  of  the  world  economy  ever  since  people  could  conceptualise  economics.  The  world  may  experience  prolonged  recession,  inflation  and  debt  crisis.  But,  it  also  has  certain  resilience.  Crises  have  a  habit  of  being  temporary.    The  real  challenge  is  to  minimise  the  pain  of  these  crisis,  and  prevent  recessions  become  prolonged,  such  as  in  the  1930s.  

Microeconomics  

Q.  What  is  the  invisible  hand  in  economics?        

It  sounds  like  a  conjuring  trick,  but  this  was  an  important  idea  popularised  by  Adam  Smith  a  great  Scottish  economist.  Adam  Smith  observed  that  in  an  economy,  the  market  would  be  very  good  at  setting  prices  and  producing  enough  goods  that  people  wanted.  He  termed  it  the  invisible  hand  because  there  is  no  actual  agency  fixing  prices.  It  just  happens  by  the  combination  of  market  forces  

• For  example,  if  coffee  becomes  more  popular  the  demand  rises.    • In  the  short  term,  firms  may  not  have  enough  coffee  to  meet  the  demand.  

Therefore  they  can  put  up  the  price.    The  higher  price  moderates  demand          • The  stronger  demand  and  higher  price  encourages  firms  to  supply  more.  

As  firms  supply  more  the  price  falls  back  down.  • This  is  a  simple  example  of  how  market  forces  respond  to  changes  in  

consumer  demand.  

The  invisible  hand  can  sometimes  work  very  quickly.  In  1999,  VHS  tapes  were  outselling  DVDs.  However,  a  few  years  later,  VHS  tapes  had  virtually  vanished  from  the  shops  as  firms  responded  to  consumer  demand  and  produced  DVDs.  

Q.  Why  are  diamonds  more  expensive  than  water,  when  water  is  more  essential  to  life?  

Economics  can  sometimes  create  a  seemingly  perverse  situation.  Why  do  we  pay  £1,000  for  a  diamond,  yet  tap  water  is  only  valued  at  £0.01  per  litre?  

• Firstly,  we  buy  a  lot  more  water  than  diamonds  during  our  lifetime.  We  may  only  buy  one  or  two  diamonds,  yet  we  buy  water  every  day.  In  our  lifetime  our  total  spending  on  water  will  be  greater  than  diamonds.  

• The  second  factor  is  the  supply.  The  supply  of  diamonds  is  very  limited.  You  can  collect  rainwater  in  your  back  garden.  You  can’t  dig  up  diamonds  in  your  back  garden.  Therefore,  because  there  is  a  real  shortage  of  diamonds,  firms  can  charge  a  high  price.  

• If  diamonds  were  as  prolific  as  pebbles  on  a  beech,  they  would  be  as  cheap  as  tap  water.  

• A  third  factor  is  something  called  marginal  utility.  If  you  buy  one  diamond  you  may  be  very  happy  (in  economics  we  say  it  gives  a  high  utility).  

• However,  the  second  diamond  will  give  less  satisfaction.  (it  gives  a  lower  utility).  If  we  have  a  hundred  diamonds,  the  101st  will  give  relatively  little  increase  in  utility.  

• However,  with  water  we  need  it  every  day.  Therefore,  it  is  giving  us  the  same  utility  every  day.  If  we  got  a  diamond  every  day,  we  would  soon  get  bored  with  the  experience.  

• Therefore,  we  are  willing  to  pay  a  huge  sum  for  a  diamond  wedding  ring,  but  we  won’t  be  buying  one  every  week.  With  water  we  will  want  to  buy  every  day.  In  our  lifetime,  our  total  spending  on  water  is  greater  than  diamonds  because  of  the  quantity  consumed.  

• To  summarise,  diamonds  are  expensive  because  they  are  very  limited  in  supply.  We  are  willing  to  pay  such  a  high  price  for  a  very  small  number.  Water  is  low  in  price  because  supply  is  plentiful,  but  we  frequently  buy  it  throughout  our  life.  

Water  is  more  important  to  us  than  diamonds,  but  we  still  end  up  paying  much  more  for  a  diamond  than  a  bottle  of  water.    However,  if  you  were  in  desert  dying  of  thirst,  you  would  probably  be  willing  to  sell  all  your  diamonds  for  a  glass  of  water.  This  shows  how  scarcity  can  suddenly  change  the  price  of  a  good.  

Q.  Why  does  the  government  like  increasing  tax  on  cigarettes  and  fuel?  

Two  reasons:  

1. Negative  externalities  of  fuel  (social  cost  higher  than  private  cost)  2. Demand  is  inelastic  (if  price  increases,  demand  falls  very  little)  

The  government  can  claim  that  driving  imposes  costs  on  the  rest  of  society  –  higher  congestion  levels,  pollution  and  accidents.  Smoking  imposes  costs  on  the  nations’  health  and  increases  the  NHS  costs.  A  tax  increases  the  cost  of  smoking  and  makes  consumers  pay  a  price  closer  to  the  social  costs.  From  an  economic  perspective,  it  is  more  efficient  if  the  price  of  smoking  reflects  its  true  social  cost.  (This  is  also  known  as  the  polluter  pays  principle).  Also,  the  money  raised  can  be  used  to  reduce  congestion  and  treat  diseases  related  to  smoking.  

A  tax  on  cigarettes  also  tends  to  increase  revenue  significantly.  If  you  are  addicted  to  smoking  and  the  price  increases,  how  much  will  your  demand  fall?  Probably  not  very  much.  Evidence  suggests  if  the  price  of  tobacco  increases  10%,  demand  falls  1%.  Therefore,  increasing  tax  on  cigarettes  leads  to  big  increase  in  tax  revenue  for  government.  It  is  an  easy  way  to  increase  tax  revenues.  

 Q.  Should  we  be  concerned  about  a  rise  in  the  price  of  oil?  

Rising  oil  prices  tend  to  reduce  living  standards.  It  is  an  important  cost  for  consumers  and  business.  If  oil  prices  increase,  we  all  face  increased  costs  of  transportation.  Because  petrol  is  a  necessity,  we  keep  buying  and  so  we  see  a  fall  in  disposable  income.  

Also,  rising  oil  prices  tends  to  cause  cost-­‐push  inflation  and  lower  economic  growth.  This  is  an  unwelcome  combination  of  factors.  

However,  as  oil  prices  increase,  it  does  change  some  incentives  which  can  help  in  the  long  term.  

• It  encourages  consumers  to  consider  other  forms  of  transport  less  dependent  on  oil.  

• It  encourages  firms  to  develop  more  efficient  engines  or  develop  forms  of  transport  which  use  other  fuel  sources.  

• Higher  oil  prices  make  the  price  closer  to  social  cost.    

Oil  is  a  finite  commodity.  At  some  time,  we  will  run  out  of  oil,  therefore  an  increase  in  the  price  of  oil  is  an  inevitability.  Rising  prices  is  the  market  response  to  the  scarcity  of  oil.  Higher  prices  do  change  behaviour  and  could  help  drive  the  development  of  energy  sources  which  create  less  pollution.  It  would  be  a  mistake  to  try  and  artificially  keep  the  price  of  oil  low.  

Q.  Why  do  firms  spend  so  much  on  advertising?  

Coca  Cola  spends  several  billion  pounds  a  year  reminding  us  that  Coca  Cola  is  a  nice  drink.  This  saturation  advertising  doesn’t  increase  the  quality  of  the  good,  it  just  makes  us  very  familiar  with  the  brand  name,  and  because  of  the  cost  of  advertising  we  end  up  paying  extra.  

Because  we  feel  Coca-­‐Cola  is  the  best,  we  become  willing  to  pay  a  higher  price.  We  could  buy  Tesco  Cola  for  a  lower  price,  but  we  don’t  see  it  as  a  good  substitute.  

Through  persistent  marketing,  Coca-­‐Cola  have  made  demand  price  inelastic.  This  means  if  the  price  increases,  we  are  still  willing  to  buy.  Therefore,  they  can  set  higher  prices  and  make  more  money.  

It  also  creates  a  barrier  to  entry.  A  new  firm  may  be  discouraged  from  entering  the  cola  market  because  it  can’t  hope  to  compete  with  the  advertising  budget  of  Pepsi  and  Coca-­‐Cola.  In  a  way  it  is  very  inefficient.  Advertising  leads  to  higher  prices,  discourages  competition  and  helps  Coca-­‐Cola  make  higher  profits.  We  could  just  buy  Tesco  cola,  but  we  know  it  isn’t  the  real  thing.  

Q.  Why  are  most  brands  of  washing  powder  made  by  just  two  companies?  

Unilever  and  Proctor  &  Gamble  dominate  the  soap  powder  market.  But,  they  each  have  multiple  brands.  If  there  were  just  two  brands  of  soap  powder,  it  would  be  easier  for  a  new  firm  to  enter  the  market.  (If  successful,  they  could  get  

33%  of  market  share.)  But,  with  30  plus  advertised  brands,  it  is  much  more  difficult.  If  successful,  you  may  only  get  3%  of  market  share.  The  irony  is  that  when  they  claim  Persil  washes  ‘whiter  than  all  the  rest’.  The  rest  are  actually  made  by  the  same  company!  

Q.  Why  is  Price  of  Coca-­‐Cola  in  Supermarket  much  more  expensive  than  a  Vending  Machine?  

In  a  supermarket,  you  can  buy  a  1.5  litre  bottle  for  £1.15.  

In  a  theme  park  or  vending  machine,  you  could  pay  £2.00  for  a  smaller  bottle  0.5  litre  bottle.  

The  main  reason  is  that  in  a  supermarket  you  do  have  alternatives.  In  a  vending  machine  or  theme  park,  coca-­‐cola  will  probably  have  a  monopoly  (the  only  choice  of  soft  drink).  Therefore,  when  there  is  no  competition  they  can  set  a  higher  price.  The  theme  park  has  a  captive  market;  you  aren’t  going  to  spend  30  minutes  going  back  outside  to  get  a  cheaper  drink.  Often  for  cinemas  and  theme  parks  it  is  selling  food  and  drink  that  is  the  most  profitable  part  of  the  enterprise.  

Q.  Why  is  Monopoly  Considered  Bad?  

When  a  firm  has  monopoly  power  it  has  the  ability  to  set  higher  prices.  If  your  tap  water  company  increase  price,  you  are  captive  to  them.  You  need  tap  water  and  you  have  no  choice,  (apart  from  buying  bottled  water  which  isn’t  practical)  The  general  idea  is  that  competition  prevents  firms  from  charging  high  prices.  A  monopoly  enables  them  to  set  higher  prices.  

It  is  also  argued  that  if  a  firm  faces  no  competition,  it  has  less  incentive  to  be  efficient  and  provide  a  good  service.  Even  if  it  is  not  attractive,  you  buy  it  because  there  is  no  alternative.  An  oft-­‐repeated  example  is  the  old  British  Rail  sandwich.  On  a  train  British  Rail  had  a  pure  monopoly  for  selling  sandwiches.  You  either  paid  £6  for  a  soggy  bacon  sarnie  or  waited  until  you  got  to  your  destination.  In  a  city  centre,  British  Rail  sandwich  shop  would  soon  go  out  of  business  trying  to  sell  the  same  sandwich  for  £6.  

Q.  Is  Tesco  Good  or  Bad?    

Tesco  has  a  degree  of  monopoly  power.  It  has  approximately  33%  of  market  share  for  UK  groceries.  In  some  areas,  Tesco  has  an  even  bigger  regional  market  share.  Tesco  will  argue  they  have  many  benefits:  

• Lower  prices.  Because  of  their  size  they  can  benefit  from  economies  of  scale  (basically  big  firms  become  more  efficient).  This  leads  to  lower  prices.  

• Popularity.  Their  growth  shows  that  people  like  shopping  at  Tesco’s  because  you  can  buy  most  things  you  want  at  a  cheap  price.  

• They  still  face  competition  from  other  big  supermarkets  keeping  prices  low.  

However,  critics  of  Tesco  argue:  

• Their  success  has  made  life  difficult  for  small  retailers  who  can’t  compete  with  the  same  levels  of  efficiency  and  economies  of  scale.  This  means  that  we  have  less  diversity  on  the  high  street.  

• Farmers  complain  supermarkets  like  Tesco  can  use  their  monopsony  buying  power  to  pay  them  lower  prices.  Because  Tesco  buys  so  much  milk,  farmers  need  to  sell  it  to  Tesco.  Therefore,  if  Tesco  is  willing  to  only  pay  a  low  price,  farmers  have  little  choice  but  to  make  low  profit.  

• Tesco  have  taken  business  from  specialist  shops  –  e.g.  selling  flowers  at  discount.  This  has  led  to  less  diversity  on  the  high  street.  

It  is  worth  bearing  in  mind  that  Tesco  is  now  one  of  the  UK’s  biggest  employers.  It’s  success  is  due  because  people  like  shopping  there.  There  is  still  room  for  specialist,  independent  stores.  However,  the  dominance  of  Supermarkets  has  led  to  a  decline  in  the  independent  stores,  which  some  people  feel  is  very  important  for  the  character  and  diversity  of  local  areas.  

Are  Monopolies  Always  Bad?  

Monopolies  can  have  benefits  for  society:  

• Patents.  A  patent  is  a  good  example  of  a  pure  monopoly.  A  legal  patent  gives  a  firm  an  incentive  to  spend  money  on  research  and  development  to  develop  new  drugs.  The  reward  of  monopoly  power  thus  creates  incentives  to  take  risks  and  invest  in  better  products  and  develop  life  saving  drugs.  However,  you  could  argue  that  drug  companies  then  exploit  this  monopoly  power  and  prevent  access  to  life  saving  drugs.  

• Monopolies  can  be  efficient.  Firms  may  gain  monopoly  power  because  they  are  efficient  and  successful.  One  view  is  that  monopolies  have  little  incentives  to  be  efficient.  But,  on  the  other  hand,  a  firm  may  gain  monopoly  power  because  it  is  efficient.  Google  created  monopoly  power  through  being  innovative  and  successful.  

Key  Terms  in  Economics    

These  are  some  key  terms  in  economics.  It  is  not  comprehensive  but  includes  some  of  the  more  common  terms.    

• GDP  (Gross  Domestic  Product)  is  a  measure  of  national  output  (the  size  of  the  economy).  

• Real  GDP  –  In  economics  ‘real’  means  we  take  into  account  inflation  (prices  going  up).  For  example,  if  your  income  doubled  from  £100  to  £200  you  may  think  you’re  better  off.  But,  if  the  price  of  all  goods  doubled,  then  your  ‘real  income’  is  still  the  same.  Real  GDP  measures  the  actual  increase  in  quantity  of  goods  and  services.  

• Economic  growth  –  This  is  an  increase  in  national  output.  The  rate  of  economic  growth  measures  the  annual  percentage  increase  in  the  size  of  the  economy.  

• Recession  –  A  fall  in  national  output.  Negative  economic  growth  (The  economy  reduces  in  size)  

• Inflation  –  This  is  the  increase  in  the  average  price  of  goods  in  an  economy.  

• Inflation  Rate  –  This  is  the  annual  percentage  increase  in  prices.  Inflation  of  3%  means  that  average  prices  are  rising  by  3%  in  a  year.  

• CPI  Consumer  Price  Index.  This  is  the  headline  rate  for  measuring  inflation.  

• Deflation  –  A  fall  in  prices.  • Unemployment  –  the  number  of  people  without  work.  • Balance  of  Payments  –  A  record  of  financial  flows  between  the  UK  and  

the  rest  of  the  world.  Note:  this  is  not  to  do  with  the  government  but  just  all  the  money  coming  in  and  going  out  of  the  UK.  

• Current  Account  on  the  Balance  of  Payments.  This  is  part  of  the  Balance  of  payments,  which  measures  exports  and  imports  of  goods  and  services,  investment  incomes,  and  net  transfers.  E.g.  a  deficit  on  the  current  account  means  we  import  more  goods  than  we  export.  

• Trade  Deficit.  This  refers  just  to  the  imports  and  exports  of  goods.  (Though  when  people  talk  of  a  trade  deficit  they  often  mean  a  current  account  deficit)  

• Interest  Rates.  The  cost  of  borrowing  money  and  also  the  amount  you  may  get  from  saving  money  in  a  bank.  

• Bank  of  England.  The  Bank  of  England  is  the  Central  Bank  of  the  UK.  They  have  responsibility  for  setting  interest  rates,  targeting  inflation  and  other  elements  of  financial  regulation.  

• Government  borrowing.  The  amount  the  government  have  to  borrow  from  the  private  sector  to  meet  their  shortfall.  

• Monetary  Policy.  Using  interest  rates  and  other  monetary  tools  (e.g.  Quantitative  easing)  to  control  inflation  and  economic  growth.  Usually  controlled  by  the  Central  Bank  e.g.  ECB  and  the  Bank  of  England.  

• Quantitative  Easing.  A  policy  by  the  Central  Bank  to  ‘create  money’  and  buy  government  bonds.  The  aim  is  to  increase  the  money  supply  and  reduce  interest  rates.  (Sometimes  referred  to  as  printing  money)  

• Fiscal  Policy.  The  use  of  government  spending  and  tax  to  influence  demand  in  the  economy.  

• Saving  Ratio.  The  %  of  income  that  is  saved  rather  than  spent.    

Exchange  Rates  

• Exchange  Rate.  The  value  of  one  currency  against  another.  E.g.  $  to  £  rate.  • Appreciation  in  Exchange  Rate.  When  one  currency  becomes  worth  

more  against  another.  • Devaluation  /  Depreciation  in  Exchange  Rate.  When  a  currency  

reduces  in  value.  • Sterling  Crisis.  When  there  is  a  fall  in  confidence  in  the  Pound  Sterling,  

causing  the  value  to  fall  sharply.  • Trade  Weighted  Index.  This  is  a  measure  of  one  currency  e.g.  Pound  

against  many  different  currencies.  It  is  weighted  to  give  more  importance  to  big  currencies  like  the  Euro  and  Dollar.  It  gives  an  overall  picture  of  how  a  currency  is  doing.  

• Monetary  Union.  When  countries  share  the  same  currency  and  monetary  policy,  e.g.  the  Euro.  

Financial  Terms  

• Government  Bond  –  A  type  of  loan  by  the  government.  • Bond  Market.  A  government  borrows  money  by  selling  ‘bonds’.  These  

bonds  can  be  bought  and  sold  on  the  bond  market.  Demand  and  supply  in  the  bond  market  will  determine  the  rate  of  interest  that  bonds  pay.  

• Stock  Market.  A  place  to  buy  and  sell  shares  in  public  companies.  E.g.  a  big  multinational  like  BT  offers  shares  as  a  way  to  raise  money.  

• Money  Markets.  A  place  where  banks  and  investment  trusts  borrow  money.  Banks  themselves  often  need  to  borrow  money  to  meet  a  shortfall  in  liquidity.  

• Short  Dated  Gilt.  –  Gilt  is  a  type  of  bond.  It  is  a  way  that  the  government  borrows  money.  Gilts  tend  to  be  short-­‐term  borrowing.  E.g.  a  three  month  dated  gilt  means  the  government  promise  to  pay  you  back  at  the  end  of  three  months.  

• Long  Dated  Bonds  –  With  some  bonds  the  government  doesn’t  have  to  pay  you  back  for  20  or  30  years.  

• Credit  Crunch.  A  situation  where  it  is  difficult  to  borrow  money  because  major  banks  are  short  of  liquidity  (money).  

• Liquidity  Crisis.  Banks  or  governments  can’t  raise  enough  money  to  meet  their  short-­‐term  requirements.  

• Lender  of  Last  Resort.  If  a  commercial  bank  runs  out  of  money,  it  can  go  to  the  Bank  of  England  who  will  lend  it  money  when  no  one  else  will.        

Housing  Market  

• Affordability.  The  ratio  of  house  prices  to  disposable  incomes.    In  the  post  war  period  house  prices  have  increased  faster  than  incomes  making  it  more  difficult  for  first  time  buyers.  

• Capital  gains  This  occurs  when  people  have  an  increase  in  the  value  of  their  assets  such  as  your  house.  This  leads  to  the  “wealth  effect”    

• Equity  Withdrawal  If  house  prices  increase,  owners  can  take  advantage  of  this  by  re-­‐mortgaging  their  house  giving  people  extra  disposable  income.  For  example  if  you  bought  a  house  for  £100,000  you  could  have  a  mortgage  for  that  amount.  If  the  value  of  the  house  increased  to  £130,000  the  bank  may  be  willing  to  lend  you  an  extra  £30,000    

• Fixed  Rate  Mortgage.  A  mortgage  where  interest  payments  are  fixed  for  a  certain  time  period,  e.g.  2  or  5  years.    

• Interest  Only  Mortgages  A  mortgage  where  you  only  pay  interest  on  the  mortgage  loan.  You  make  no  payment  to  reducing  the  outstanding  mortgage  debt.          

• Mortgage  repayments:  To  buy  a  house,  people  have  to  borrow  money.  Therefore  they  take  out  a  mortgage,  this  loan  is  then  paid  back  in  monthly  mortgage  repayments    

• Negative  Equity.  This  occurs  when  there  is  a  fall  in  the  real  value  of  the  house.  It  means  that  if  somebody  wanted  to  sell  their  house  they  would  get  less  for  it  in  real  terms  than  the  original  buying  price.    

• Stamp  duty  This  is  a  tax  that  is  paid  on  buying  a  new  house.  The  more  expensive  it  is,  the  more  tax  that  is  paid.    

• Wealth  Effect  The  most  common  form  of  peoples’  wealth  is  their  house.  If  house  prices  increase,  people  feel  wealthier  and  therefore  spend  more  causing  an  increase  overall  demand  in  the  economy.  

Notes:  

Data on interest rates published with permission of Bank of England. See Bank of England Revisions Policy (http://www.bankofenqland.co.uk/mfsd/iadb/notesiadb/Revisions.htm).