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 doesnt 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 isnt 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 dont believe higher government spending can help the economy).
They argue higher government spending wont 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 Governments 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 cant 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 isnt 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. Chinas
growth has averaged close to 10%; this is much higher than the UKs 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. Chinas growth
has been largely based on exports. The process of globalisation has
helped create a large global market for Chinas exports.
5. Weak Chinese Currency. A factor that has contributed to Chinas 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 isnt the main reason for economic growth in China, but
it has helped provide an extra boost to export demand.
At this stage in Chinas 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 isnt 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 dont 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 wouldnt 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 didnt 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 doesnt 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 cant 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 isnt 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 doesnt
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 cant 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
dont 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 wouldnt 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 isnt 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 wont 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 peoples 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. Todays 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 governments 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 dont 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 doesnt. 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 dont 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 wont 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 couldnt 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 cant 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, isnt 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
governments 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 dont 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
doesnt 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 doesnt 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 doesnt 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 doesnt 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
wont 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 wont 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 didnt 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 wont 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 UKs 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 dont 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 isnt bankrupt doesnt mean we dont 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 everyones 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 dont 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 dont 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 doesnt 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 dont 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.
Japans 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 cant
ask their Central Bank to buy government debt. Also they cant 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, doesnt 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 governments 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 didnt 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
dont have this option because:

They cant devalue

They cant 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 isnt a financial flow from China to UK. What
would happen if China didnt 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 cant 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 cant 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 cant 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 dont
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 dont 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 doesnt 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 didnt 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 wont 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 didnt follow suit.
The commercial banks didnt 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 didnt lend money for
investment.

Q. How Do Banks Work?

When you deposit 1,000 at a bank. It doesnt 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 wont 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 couldnt pay them back. This occurred
particularly in the US, where banks gave mortgages to people on low incomes
who couldnt really afford them. When people couldnt 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 didnt 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 didnt want to bailout the banks, but, at the same time, they
didnt 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 couldnt find the funds to pay all the depositors.
The money was tied up in long-term mortgages and other loans.

If the bank couldnt 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 dont 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 wont 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 couldnt 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: Doesnt 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 dont 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 doesnt 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 didnt have. In other words they borrowed money to lend to other people,
but then people defaulted (couldnt 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 couldnt pay the expensive mortgage they took
out.
8. As people couldnt pay mortgages, people sold houses and demand for
buying a house declined. This caused a fall in house prices, which
many didnt expect.
9. Banks lost money because people defaulted on their mortgage, but
also house prices were falling rapidly. This meant they couldnt 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 couldnt 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 couldnt devalue the exchange rate to restore
competitiveness. This led to persistently low growth, which aggravated their
existing debt problem.
By contrast, the UK wasnt 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

Its 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 didnt 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 dont 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 couldnt 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 cant 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 worlds 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
wont 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 wont 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 dont 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 dont 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 doesnt 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 shouldnt 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 cant 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 peoples 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 didnt
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
wont 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 cant
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 didnt 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 didnt 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 Dont 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 dont
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 shouldnt
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
governments 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 Peoples 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 Britains economy.
A key issue was the governments 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 UKs 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 didnt
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 Labours 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 didnt 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 didnt 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 Thatchers 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 didnt 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.

Miners Strike 1984

In 1974, the coal miners strike arguably helped defeat Ted Heaths 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 didnt 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
wasnt 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 governments 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 didnt 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 couldnt reverse the fall in demand.

The whole banking sector was short of liquidity and so didnt want to lend.

Lower base rates didnt 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 UKs 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 Didnt 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 didnt 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 UKs 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.
Spains debt to GDP ratio 37%

Irelands 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 wasnt 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 cant 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 cant devalue the exchange rate to boost competitiveness (they are
in the Euro)
They cant pursue expansionary monetary policy (ECB wont 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 growthwhich it often does. (2011 in Review:
Four Hard Truths)

Individual Cases
Ireland
Irelands 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
Italys 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 couldnt 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.
Its 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 doesnt 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 shouldnt 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 governments 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 cant 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, Ill 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) dont devalue, its
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 doesnt 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 wasnt 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 wont 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 cant 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 wont 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 doesnt 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 dont 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 cant 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 isnt 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 arent 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 isnt 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 Tescos
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 cant 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 UKs biggest employers.
Its 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 youre 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 doesnt 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 cant 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).