Case Study Mind your Business

The News 22 September 2003

OK, this one is going to be a bit tricky, you have got your AS and are now expected to hit a higher level in your understanding. The macro-economy material is confusing as it is! Today we are going to bombard you, not with a story, but with a host of figures. We will then try to explain some of these figures in the 'Theory' section and then set an exercise designed to assess how well you can interpret these figures, put them together and come up with a coherent analysis of the economy as a whole. This topic is not only for those studying economics, it is also highly relevant for business studies - after all, any business worth its salt knows that it needs to be aware of the external factors that could influence the businesses future! This last week has been a good one for stato's. The International Monetary Fund (IMF) published its half yearly view of the world's economies and there have been a number of figures published on the UK economy. Let's have a look at the 'highlights'.

Trend Growth: 2 .75 % Actual growth: 1.7% Gordon Browns' forecast growth: 2 - 2.5% PSNCR - Target for year 27 billion; expected level : 37 billion Interest Rates: 3.5% RPI :year to August 2003: 2.9% (down from 3.1% in year to July 2003 RPIX: Year to August 2003: 2.9% up by 0.3% on previous month Government Target rate for inflation: 2.5% (Permitted band: 1.5% - 3.5%) Average Earnings: 3.4% up from 3.1% in July Consumer spending: up 3.8% House Price Inflation: 17% but slowing! Demand for Mortgages: August - 5.3 billion (down from July's figure of 5.5 billion) Unemployment: Claimant Count: down 6,900 at 930,800 ILO measure: (number out of work for the post 3 months) down 1,000 to 1,493,000 Employment: Number in work up 63,000 to 27.9 million (highest ever) Trade Gap: -4.5 billion in June 2003 (up from -4.1 billion in May 2003) A bit of commentary: analysts are debating whether the Bank of England's Monetary Policy Committee (MPC) will have to think about increasing interest rates in the near future as consumption continues to grow at a higher rate than expected. The trade gap surprised some analysts. The GBP () has been depreciating which should reduce the trade gap but weak demand from abroad has offset the effects of depreciation. It is the tenth month in a row that the inflation level has exceeded the Government's target rate of 2.5%. Manufacturing industry is still suffering and is shedding jobs. In other areas of the economy, employers are reporting skill shortages. Economic growth remains below its trend rate suggesting that there is a deflationary gap.

Questions Having been presented with quite a large amount of information and theory, it is now time to see how far you can interpret the information you have been given. 1. You are a Civil Servant in the Treasury. Write a report of 700 words advising the Chancellor of the Exchequer and the Governor of the Bank of England of the current state of the UK economy. You need to use the data provided in the theory section and explain your views using appropriate economic theory. The outcome should highlight the extent of the impact of the economic data you have been given on the key government economic targets of economic growth, inflation, unemployment and the balance of payments.

2. The emphasis of the piece is to present a coherent argument that is concise but detailed. You will be assessed on the extent to which you are able to analyse the facts given and evaluate the possible impact of this data.

Theories 1. Aggregate Demand (AD): AD = C + I + G+(X-M) Where: C = Consumption expenditure (spending on food, clothes, leisure, furniture, books, CDs etc etc); I = Investment expenditure - spending on new equipment and machinery by businesses; G = Government spending - all the money spent on education, health, defence, emergency services, social security and so on; X = money earned through export sales abroad; M = money spent on buying goods and services from abroad; (therefore X-M is net exports). 2. Aggregate Supply (AS) The total amount of output in the economy - the ability of the economy to produce goods and services at different price levels - the capacity of the economy. Most A' level courses expect an understanding of the basic AS/AD model. The way we have presented it below is based on a number of assumptions - if you go to university to study economics these will become clearer but they are not necessary to go into at this stage! Notice that we have labelled the vertical axis 'Inflation' - you will find that most textbooks have 'price level' or just 'price' on the vertical axis. This reflects recent thinking in macro-economic circles that changes in the way that most governments around the world control their economies (primarily through monetary policy) make this far more realistic; after all it is very rare (except in Japan recently) for the price level to fall (i.e. for prices to drop). Therefore, we would associate different levels of growth or national income to be associated with different rates of inflation. We can use this basic model to explore some of the figures given above in more detail.

The model shows the economy in an equilibrium position with inflation currently standing at 2.9% and output at Yo. This output level is consistent with a current rate of unemployment of 5%. We can now use changes in the AS and AD curves to analyse what happens to the whole economy. The problem is that we need to make some judgements about the extent to which the factors we have highlighted in the 'News' section above will affect these curves. This is why economists use the famous 'ceteris paribus' phrase - 'other things remaining equal' it allows us to identify what the effect of the change in one factor might be whilst recognising that in reality all these other things do not remain constant! Any change in factors affecting consumption will shift the AD curve either to the left or to the right. If, for example, incomes are rising it is likely to cause the AD curve to shift to the right. The consequences of a rightward shift in AD are that inflation will increase and national income will rise. The implication from this is that unemployment will also fall since it is assumed that more workers are needed to produce a greater output. Any change in either C, I, G or (X-M) will therefore affect AD. What you will need to do is to identify which factor the data given affects and then trace through the implications. One problem however, is that all these things are changing at the same time; your skill in making a judgement as to the extent of the effects on AD in total will be crucial. If AD rises dramatically then it would have a more significant impact on inflation and output than if it only shifted by a small amount. Next we look at aggregate supply (AS). The aggregate supply curve will be affected by a number of factors; productivity rates, the quantity and quality of resources within the country, the quantity and quality of our human resources, the flexibility and responsiveness of markets to change, the level of innovation, incentive and enterprise in the economy and the expectations of those involved in production. You can see that these factors are far more nebulous (woolly, harder to pin down) than those affecting AD! What this suggests is that changes in AS will be more long term in nature. Yesterday (18th September 2003) for example, Tony Blair the British Prime Minister, opened a new business and

enterprise school in Bexley, Kent. The school is hi-tech, innovative, bright, spacious and quite unlike most other schools in the UK. Such an investment (it cost 30 million) is only likely to lead to changes in the quality of human resources (assuming of course that it does!) in the long term. How you encourage an enterprising economy, raise incentives and increase productivity has proved to be rather more difficult that it might sound. You will notice that the AS curve is sloped. The slope is upwards from left to right and at the right hand side, the slope becomes steeper. This is meant to represent the fat that as national income levels rise, it becomes harder for the economy to continue expanding at the same rate because resources become ever scarcer. Notice that in the 'Theory' section we commented on skill shortages. Businesses may want to expand to meet current demand but find it hard to attract the resources - especially labour resources - they need to continue expanding. The theory also mentions the difference between potential growth and actual growth. Potential growth is the rate at which the economy could grow if it was using all its resources to their fullest capacity. Actual growth is the rate of growth in national income year on year - usually measured by Gross Domestic Product (GDP) or Gross National Product (GNP). If actual growth is below potential growth, then it suggests that there is room for the economy to grow without putting undue pressure on inflation - in other words at the flatter part of the AS curve. You will notice that we have a vertical line on the right of the diagram labelled Yf. This is full employment national Income. In theory, there may be an upper limit of output beyond which the economy, with its existing resources, cannot go beyond. The closer AS gets to this point, the greater the skill shortages and resource constraints on expansion will be. It is possible to shift this point further to the right through increases in AS, but as we have seen this may be a long term process. 3. One last point of theory. The PSNCR (Public Sector Net Cash requirement). Some textbooks refer to this as the PSBR (Public Sector Borrowing Requirement - the terminology has changed but the essence is still the same). The PSNCR refers to the amount of money that the government needs to borrow to finance its spending plans. Governments receive income through tax revenue; in part this tax revenue is dependent upon the success of the economy - if people are spending and earning, then tax revenue will increase. Governments also have to pay back loans - primarily through borrowing via the issue of bonds (gilt edged stock). In some periods, the government may not need to borrow as much as they pay back, in others the government may need to borrow more than they pay back in that time period. The PSNCR therefore is a measure of the net cash requirement; if it is positive then it means the government are borrowing to finance its expenditure. Tax revenue can be unpredictable so governments may need to increase borrowing if tax revenue falls below expected levels. If the government borrow, however, then there is pressure in the market for loans and this could lead to increases in the rate of interest.