Adding to the Circular Flow and the Value of the Economy

8/2/2019 Adding to the Circular Flow and the Value of the Economy

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ADDING TO THE CIRCULAR FLOW AND THE VALUE OF THE ECONOMY

- Businesses may invest money into new equipment or new factories. This allows extra production totake place.- The Government may spend 100 mn on a roadbuilding project. This creates economic activity- An export is a sale of a good or service to a foreigner. This brings money into the economy.

LOWERING THE CIRCULAR FLOW AND THE ECONOMIC ACTIVITY

Savings mean that people are not spending money on goods and servicesTaxes are taken out of peoples and businesses incomes. This money cannot be spent on goods andservices.Imports are purchases from abroad. The money leaves the country

Macro-economic equilibrium is established when AD intersects with SRAS. This is shown in thediagram below. At price level P1, AD is equal to SRAS i.e. at this price level, the value of outputproduced within the economy equates with the level of demand for goods and services. The outputand the general price level in the economy will tend to adjust towards this equilibrium position. Ifthe general price level is too high for example, there will be an excess supply of output andproducers will experience an increase in unsold stocks. This is a signal to cut back on production toavoid an excessive level of inventories. If the price level is below equilibrium, there will be excessdemand in the short run leading to a run down of stocks a signal for producers to expand output.


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DETERMINANTS OF AGGREGATE DEMAND

Factors causing a shift in AD

Changes in ExpectationsCurrent spending is affected byanticipated future income, profit,and inflation

The expectations of consumers and businesses can have a powerful effect onplanned spending in the economy E.g. expected increases in consumerincomes, wealth or company profits encourage households and firms to spendmore boosting AD. Similarly, higher expected inflation encourages spendingnow before price increases come into effect - a short term boost to AD.When confidence turns lower, we expect to see an increase in saving andsome companies deciding to postpone capital investment projects because ofworries over a lack of demand and a fall in the expected rate of profit oninvestments.

Changes in Monetary Policy i.e. achange in interest rates

(Note there is more than oneinterest rate in the economy,although borrowing and savings ratestend to move in the same direction)

An expansionary monetary policy will cause an outward shift of the AD curve.If interest rates fall this lowers the cost of borrowing and the incentive to

save, thereby encouraging consumption. Lower interest rates encourage firmsto borrow and invest.There are time lags between changes in interest rates and the changes on thecomponents of aggregate demand.

Changes in Fiscal PolicyFiscal Policy refers to changes in

government spending, welfarebenefits and taxation, and theamount that the governmentborrows

For example, the Government may increase its expenditure e.g. financed by ahigher budget deficit, - this directly increases AD

Income tax affects disposable income e.g. lower rates of income tax raisedisposable income and should boost consumption.An increase in transfer payments raises AD particularly if welfare recipientsspend a high % of the benefits they receive.

Economic events in theinternational economyInternational factors such as the

exchange rate and foreign income(e.g. the economic cycle in othercountries)

A fall in the value of the pound () (a depreciation) makes imports dearer andexports cheaper thereby discouraging imports and encouraging exports thenet result should be that UK AD rises the impact depends on the price

elasticity of demand for imports and exports and also the elasticity of supplyof UK exporters in response to an exchange rate depreciation.An increase in overseas incomes raises demand for exports and therefore UKAD rises. In contrast a recession in a major export market will lead to a fall inUK exports and an inward shift of aggregate demand.The UK is an open economy, meaning that a large and rising share of ournational output is linked to exports of goods and services or is open tocompetition from imports.

Changes in household wealthWealth refers to the value of assetsowned by consumers e.g. houses andshares

A rise in house prices or the value of shares increases consumers wealth andallow an increase in borrowing to finance consumption increasing AD. Incontrast, a fall in the value of share prices will lead to a decline in householdfinancial wealth and a fall in consumer demand.


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DETERMINANTS OF SHORT-RUN AGGREGATE

SUPPLY

Money Wage rates

Business Taxation

Productivity

DETERMINANTS OF LONG-RUN AGGREGATE

SUPPLY

The fundamentals of increasing long run aggregate supply

These all relate to the supply-side of the economy

Expanding the labour supply - e.g. by improving incentives for people to search for andthen accept new jobs as they become available. Government policies seek to expand theavailable labour supply by encouraging more people to join the labour force and becomeeconomically active. The UK government has also been encouraging an influx of migrantlabour which has added to the supply of labour although it is also causing concern about someof the social and political effects.

Increase the productivity of labour and capital e.g. by investment in training of the labour

force and improvements in the quality of management and human resource management

Increase the occupational and geographical mobility of labour to reduce certain types ofunemployment for example the level of structural unemployment which is caused byoccupational immobility of labour. A reduction in structural unemployment will reduce thescale of unemployment and provide the economy with a great supply of available labour.

Expand the capital stock i.e. increase the level of capital investment and research anddevelopment spending by firms

Increase business efficiency by promoting greater competition within and between markets

Stimulate a faster pace of invention and innovation this will hopefully in the long term

promote lower production costs and also improvements in the dynamic efficiency of markets


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What are the major objectives of macroeconomic policy?

The four major objectives are (i) full employment, (ii) price stability, (iii) a high, but sustainable,rate of economic growth, and (iv) keeping the Balance of Payments in equilibrium. First, we will lookat the way in which these objectives are measured. Secondly, we shall discuss the relative import-ance of these objectives. Thirdly, we shall see how successful recent governments have been inachieving these goals. Finally, we will look at the difficulties that governments have in trying toachieve all the objectives at once.

How are these objectives measured?

1. Full employment, or low unemployment

The claimant count is the older, more out of date measure of unemployment used in the UK. Thosecounted must be out of work, physically able to work and looking for it, and actually claiming bene-fit.

For a more realistic count, and for international comparisons, the ILO (International Labour Organisa-tion) measure is used. This includes the young unemployed who are not always eligible to claim, mar-ried women who can't claim if their husband is earning enough, and those who claim sickness and in-validity benefits. Many only slightly inconvenienced unemployed workers are paid these benefitsrather than swell the unemployment numbers.

Note the issue of active and inactive members of the population of working age. Only those who areactive are included in the working population, which is defined as all those who are employed or re-gistered unemployed. But some of the inactive are in this category by choice, for instance, studentsand those who retire early.


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2. Price stability

Inflation is usually defined as a sustained rise in the general level of prices. Technically, it is meas-ured as the annual rate of change of the Retail Price Index (RPI), often referred to as the headlinerate of inflation. For prices to be stable, therefore, the inflation rate should be zero. Generally, gov-ernments are happy if they can keep the inflation rate down to a low percentage. For an explanationof how the RPI is formulated, see later. The UK government prefers to target the underlying rate ofinflation, or the annual percentage change in the RPIX. This is the same as the RPI except housingcosts are removed in the shape of mortgage interest payments. It makes sense for the government touse this measure because the weapon they use to control inflation, interest rates, directly affects theRPI itself.

Other less popular measures include the RPIY, which takes RPIX a stage further by also taking out theeffects of indirect taxation (e.g. VAT), and the consumer price index, which is often used when mak-ing international comparisons.

3. High (but sustainable) economic growth

Economic growth tends to be measured in terms of the rate of change of real GDP (Gross DomesticProduct). When the word real accompanies any statistic, it means that the effects of inflation havebeen removed. More on this later! GDP is a measure of the annual output (or income, or expenditure)of an economy. Much more on this later! Sometimes GNP (Gross National Product) is used, which isvery similar to GDP. Growth figures are published quarterly, both in terms of the change quarter onquarter and as annual percentage changes.


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4. Balance of Payments in equilibrium

Briefly, this records all flows of money into, and out of, the UK. It is split into two: the Current Ac-count and the Capital and Financial Accounts (formerly the capital account).

Probably the most important is the Current Account because this records how well the UK is doing interms of its exports of goods and services relative to its imports. If the UK is to 'pay its way' in theworld over the long term, then it needs to keep earning enough foreign currency from its exports topay for its imports. If this is not the case, the account will be in deficit. Japan has the largest surplusin the world. Although a surplus sounds better then a deficit, both can be bad. Japan's surplus forcesother countries in the world to have deficits. In fact, while Japan's surplus is the biggest in the world,the USA's deficit is the biggest in the world. This is not a coincidence! The UK tends to be in deficit,

although the Current Account was in surplus a couple of years ago, mainly due our strength in the ser-vice sector.

Which objective is the most important?

In the 1960s, the Balance of Payments was considered very important. A deficit was considered highlyembarrassing in the days when many still believed, mistakenly, that Britain was a world power. The

long term sustainability of a deficit was a big problem in the days before global free movements ofcapital, and so sterling would be affected which was unacceptable within the 'Bretton Woods' fixedexchange rate system. Nowadays, with a floating pound and huge global capital flows, many econom-


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ists believe that balance of payments deficits or surpluses simply do not matter. This was reflected inthe fact that nobody seemed to bat an eyelid at the continual deficits of the 90s.

Full employment was considered very important after the Second World War. It was probably thenumber one objective of the socialist government of the late 40s and continued to be at the front ofpoliticians' minds for the next three decades. Unemployment exploded under Thatcher in the 80s, butit was seen as an inevitable consequence of the steps taken to make industry more efficient. It waspainful at the time but the lower levels of unemployment today are due, in part, to the structuralchanges made in the 80s. The fact that de-industrialisation was occurring throughout the westernworld also made higher unemployment feel inevitable, and so this objective became much less im-portant than it had been.

Growth and low inflation have always been important. Without growth peoples' standard of livingwill not increase, and if inflation is too high then the value of money falls negating any increase inliving standards. Nowadays these are definitely the two most important objectives of UK macroeco-nomic policy. The Chancellor is always going on about 'sustainable growth', meaning growth withoutinflation. Probably the biggest piece of economic news each month is the decision taken by the Mon-etary Policy Committee (MPC) over interest rates, their sole objective being the 2.5% target for thegrowth in RPIX (plus or minus 1%). It is probably worth noting at this stage: do not confuse objectivesof macroeconomic policy with the instruments used to achieve these aims. Low inflation is an object-

ive, the rate of interest is an instrument used to control inflation, not an objective in itself.

If one had to pick the most important objective today, it would have to be inflation. Although itshould be growth, all government's efforts are devoted to the control of inflation. If this goal ismissed, it is felt, then the goal of higher growth will not be attainable either.

How successful have recent governments been in achieving these goals?

On growth, there tends to be periods of strength (booms) followed by periods of weak or even negat-ive growth (recessions). This is known as the economic cycle. All governments have a goal of elimin-ating this cycle. In other words, they want continual, reasonable growth that never ignites inflation,

perhaps 2?% - 3% per annum. Recent governments have moved closer to this 'Goldilocks' scenario. No-tice that the growth rate has been over 2% without getting out of hand for six years. Following thebust/boom/bust of the early 80s/late 80s/early 90s, this is quite an achievement.

Inflation has also been remarkably subdued by historical standards. Following the horribly inflationary70s (peaked at 25%) and the near 10% figure ten years ago, RPIX has been growing at 3% pa or less forsix years.

The goal of full employment has effectively been consigned to the history books. Unemploymentreached one million in the 80s for the first time since the 30s, and then proceeded to reach 3 million(or 4 million, depending on the definition) within three years. Having said that, 'full employment'does not mean that everyone has a job. Even in the 'full employment' era of the 50s there were still300,000 unemployed. Today's figure is falling towards one million which some consider to be fairlyclose to full employment given the increased flexibility of the UK labour market (much more on thatin the upper sixth).

It is a sad fact of economic life that UK consumers prefer imported goods to those made in Britain.The extent of the current account deficit mainly depends, therefore, on how well we export our ser-

vices. Unfortunately, services are not quite as exportable as goods, so the UK is always fighting a los-ing battle. Hopefully the changes in technology, and our abilities to exploit them, will allow us to in-crease our exports of services by enough in the future to allow for the deficit in goods. Some econom-ists believe that there is no problem, because in a world of perfectly mobile capital, the UK no longerrelies entirely on their own pool of foreign reserves to pay for its imports. Nowadays, if you wantsomething from abroad but you do not have the foreign currency, then just buy it on the Foreign Ex-change Markets!

Are there any conflicts between these objectives?

Unfortunately, it is virtually impossible for a government to score in all these goals at once. We shallbegin with the three major conflicts and then look at two more that are linked to microeconomics.

1. Healthy growth and low inflation

If an economy grows too quickly, especially if it is due to excessive consumer spending as it tends tobe in the UK, then demand will outstrip supply and prices will rise. Equally, the steps taken to keep


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inflation low, like relatively high interest rates, can often restrict growth via reduced consumerspending and investment. It is difficult to achieve both aims.

The 'trend' rate of growth is seen as the rate of growth an economy can grow without igniting infla-

tion. Most economists believe that this is around 2?% to 3% at the moment. For the last six years theUK has managed to walk this tightrope without slipping into either higher inflation or recession. Per-haps the economic cycle has been eliminated, but most economists find this difficult to believe.

2. Healthy growth and a Balance of Payments equilibrium

When an economy is growing quickly, consumer spending tends to be high. As we have already noted,British consumers tend to buy goods from abroad in preference to home produced goods. Hence, im-port growth picks up relative to exports, assuming an average growth rate in the countries that buyBritish goods, leading to a worsening trade deficit. In the old days when the Balance of Payments wasseen as possibly the most important macroeconomic objective, either the exchange rate would give,or import controls were used (not possible these days with the World Trade Organisation), or the gov-

ernment had to deflate the economy, implying a low rate of growth.3. Low unemployment (or full employment) and low inflation

This is the classic conflict in economic theory. In fact, an economist called Phillips constructed acurve using empirical data to show that this conflict existed (although this did not mean that the re-lationship would hold forever).

These two variables have, in theory, an inverse relationship. If a government tries to reduce unem-ployment through reflationary measures, such as lower interest rates or increased public spending,then the resulting reduction in unemployment will push wages, and then prices, higher. On the otherhand, when the government tries to control high inflation with higher interest rates and reducedspending, the resulting reduced consumer spending and lower investment will result in job losses.Norman Lamont, Conservative Chancellor of the early 90s, famously said 'unemployment is the priceworth paying for lower inflation.'


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Economic Growth

Growing economies provide the means for people to enjoy better living standards and for more of usto find work. But what is economic growth and how best can a country achieve it?

Defining economic growth

Economic growth is best defined as a long-term expansion of the productive potential of the eco-nomy. Sustained economic growth should lead higher real living standards and rising employment.Short term growth is measured by the annual % change in real GDP.

Growth and the Production Possibility Frontier

An increase in long run aggregate supply is illustrated by an outward shift in the PPF.
http://en.wikipedia.org/wiki/Economic_growthhttp://en.wikipedia.org/wiki/Economic_growth


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Advantages of Economic Growth

Sustained economic growth is a major objective of government policy not least because of the be-nefits that flow from a growing economy.

Higher Living Standards for example measured by an increase in real national income perhead of population see the evidence shown in the chart below

Employment effects: Growth stimulates higher employment. The British economy has beengrowing since autumn 1992 and we have seen a large fall in unemployment and a rise in thenumber of people employed.

Fiscal Dividend: Growth has a positive effect on government finances - boosting tax revenuesand providing the government with extra money to finance spending projects

The Investment Accelerator Effect: Rising demand and output encourages investment innew capital machinery this helps to sustain the growth in the economy by increasing longrun aggregate supply.

Growth and Business Confidence: Economic growth normally has a positive impact on com-

pany profits & business confidence good news for the stock market and also for the growthof small and large businesses alike

Rising national income boosts living standards

And an expanding economy provides the impetus for a rising level of employment and a falling rate ofunemployment. This has certainly been the case for the British economy over the last decade.

Disadvantages of economic growth

There are some economic costs of a fast-growing economy. The two main concerns are firstly thatgrowth can lead to a pick up in inflation and secondly, that growth can have damaging effects on ourenvironment, with potentially long-lasting consequences for future generations.

Inflation risk: If the economy grows too quickly there is the danger of inflation as demandraces ahead of aggregate supply. Producer then take advantage of this by raising prices for


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consumers

Environmental concerns: Growth cannot be separated from its environmental impact. Fastgrowth of production and consumption can create negative externalities (for example, in-creased noise and lower air quality arising from air pollution and road congestion, increasedconsumption of de-merit goods, the rapid growth of household and industrial waste and the

pollution that comes from increased output in the energy sector) These externalities reducesocial welfare and can lead to market failure. Growth that leads to environmental damagecan have a negative effect on peoples quality of life and may also impede a countrys sus-tainable rate of growth. Examples include the destruction of rain forests, the over-exploita-tion of fish stocks and loss of natural habitat created through the construction of new roads,hotels, retail malls and industrial estates.

Many economists and environmentalists are concerned about the impact that rapid economic growthcan have on our limited scarce resources and our environment.

The trend rate of economic growth

Another way of thinking about the trend growth rate is to view it as a safe speed limit for the eco-nomy. In other words, an estimate of how fast the economy can reasonably be expected to grow overa number of years without creating an increase in inflationary pressure.

Above trend growth positive output gap: If the economy grows too quickly (much fasterthan the trend) then aggregate demand will eventually exceed long-run aggregate supplyand lead to a positive output gap emerging (excess demand in the economy). This can lead todemand-pull and cost-push inflation.

Below trend growth negative output gap: If the economy experiences a sustained slow-down or recession (i.e. growth is well below the trend rate) then output will fall short of po-tential GDP leading to a negative output gap. The result is downward pressure on prices andrising unemployment because of a lack of aggregate demand.

Demand and supply factors influence growth of GDP

Many factors influence the rate of economic growth. Some factors, such as changes in consumer andbusiness confidence, aggregate demand conditions in the UKs trading partners, and monetary andfiscal policy, tend to have a mainly temporary effect on growth. Other factors, such as the rates ofpopulation and productivity growth, have more enduring effects, and help to determine the eco-nomys average growth rate over long periods of time.

Adapted from a Treasury paperwww.hm-treasury.gov.uk

The importance of the supply-side of the economy
http://www.hm-treasury.gov.uk/http://www.hm-treasury.gov.uk/http://www.hm-treasury.gov.uk/


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The trend rate of growth is determined mainly by the supply-side capacity of a country i.e. the ex-tent to which LRAS increases year-on-year to meet a higher level of demand for goods and services.Potential output in the long run depends on the following factors

The trend growth of the working population i.e. the size of the active labour supply (e.g.those people able available and willing to find paid employment)

The growth of the nations stock of capital driven by the level of capital investment in newbuildings, machinery, plant and technology

The trend rate ofgrowth of factor productivity (including labour productivity) a measureof gains in factor efficiency

Technological improvements driven by innovation and invention which reduce the costs ofsupplying goods and services and which lead to an outward shift in a countrys productionpossibility frontier

Long Run Aggregate Supply and the Trend Rate of Growth

The effects of an increase in long run aggregate supply are traced in the diagram below. An increase

in LRAS allows the economy to operate at a higher level of aggregate demand leading to sustainedincreases in real national output.

Potential output in the long run depends on the following factors

(1) The growth of the labour force e.g. those people able available and willing to find employment

If the government can increase the number of people willing and able to actively seek paid employ-ment, then the employment rate increases leading to a higher output of goods and services. The Gov-ernment has invested heavily in a number of employment schemes designed to raise employment in-cluding New Deal and reforms to the tax and benefit system. Changes in the age structure of thepopulation also affect the total number of people seeking work. And we might also consider the ef-fects that migration of workers into the UK from overseas, including the newly enlarged EuropeanUnion, can have on our total labour supply

(2) The growth of the nations stock of capital driven by the level of fixed capital investment.

A rise in capital investment adds directly to GDP in the sense that capital goods have to be designed,produced, marketed and delivered. Higher investment also provides workers with more capital to


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work with. New capital also tends to embody technological improvements which providing workershave sufficient skills and training to make full and efficient use of their new capital inputs, shouldlead to a higher level of productivity after a time lag.

(3) The trend rate of growth of productivity of labour and capital . For most countries it is thegrowth of productivity that drives the long-term growth. The root causes of improved efficiencycome from making markets more competitive and achieving better productivity within individualplants and factories. Increased investment in the human capital of the workforce is widely seen asessential if the UK is to improve its long run productivity performance for example increasedspending on work-related training and improvement in the UK education system at all levels.

(4) Technological improvements are important because they reduce the real costs of supplyinggoods and services which leads to an outward shift in a countrys production possibility frontier

The current growth phase for the UK is the longest period of continuous growth for over forty years.

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Adding to the Circular Flow and the Value of the Economy