01 Inflation is the rate at which the average price level of goods and services rises in a given time period. In the UK, the Office for National Statistics uses two main indices to measure inflation: the Consumer Prices Index (CPI) and the Retail Prices Index (RPI).
The role of inflation expectations in influencing future inflation was an area of economic analysis developed by Professor Milton Friedman in the 1970s. Friedman argued that workers and firms pay careful attention to their past experiences when developing expectations about future inflation. If they have experienced inflation in the past, workers will expect prices to go up in the future and will make pre-emptive wage demands on the ground that without an inflation-adjusted pay rise they will experience a pay cut in real terms. This behaviour will actually create the conditions for inflation. Confronted with increased wage demands and accepting the inflationary record of the past, firms will give in to higher wage demands and pass on the cost increases to consumers in the form of higher prices.
Changes in costs of production will also affect inflation. In the summer of 2008 the UK experienced increased inflation as the price of energy increased in world markets. In July 2008 the price of oil broke the $100 a barrel mark for the first time, although it did fall sharply after the financial crisis. It has, however, risen steeply again due to the high levels of demand from the emerging markets which may well see the price of a barrel of oil break the $200 mark in the next few years. The British economy is dependent upon oil as a major source of energy, so when oil prices increase, the costs of production of almost all firms increase either directly or indirectly. This feeds into the inflation indexes.
Cost-push inflation is illustrated on the aggregate demand and supply diagram below. Initially, macroeconomic equilibrium is at point X, with real output and the price level respectively at y1 and P1. Firms’ money costs of production rise — for example because money wages or the price of imported raw materials increase — which causes the SRAS curve to move upward and to the left from SRAS1 to SRAS2. The cost-push inflationary process increases the price level to P2, but higher production costs have reduced the equilibrium level of output that firms are willing to produce to y2. The new macroeconomic equilibrium is at point Z.
It should be noted that falling costs of production can also result in benign deflation. The UK experienced a decade of low inflation between 1997 and 2007 caused by falling costs of production as firms benefited from technological advances that revolutionised production methods and significantly lowered labour costs by out-sourcing production to southeast Asia.
The mark scheme for the first part (01) of an essay question is ‘issue based’. The mark scheme sets out all the issues deemed to be relevant to the question and indicates the maximum marks that can be awarded for each issue. The total mark is usually higher than 15, which is the maximum mark for the first part of an essay question. So when an answer earns more than 15 marks, the mark awarded is constrained to the maximum of 15. This is the case with this answer. Both parts of the question are addressed accurately, earning well over 15 marks but the mark awarded is the maximum 15. By the time you read this answer, the reasons for recent and current inflation quoted by the candidate may have changed. In the early months of 2012, for example, falling world oil prices meant that cost-push inflationary pressures were considerably less than they had been in the earlier years quoted by the candidate.
02 The Keynesian economist A. W. Phillips developed short-run Phillips curve analysis in the 1950s. Phillips had researched the relationship between inflation and unemployment over a 100-year period and found that there was a relationship between the two variables that could be illustrated as in the diagram below.
The Keynesian economists of the1950s and 1960s used this curve to present government officials with a ‘menu choice’. They could pick either: low inflation and high unemployment (position A on the diagram); or high inflation and low unemployment (position B on the diagram).
The 1970s saw a prolonged period of mass unemployment and double-digit inflation which led to widespread disillusionment with Keynesian economics. The neo-liberal economic revolution associated with the 1980s governments of Margaret Thatcher in the UK and Ronald Reagan in the USA was inspired by the revival of free-market economics.
Milton Friedman from the Chicago School was particularly critical of the Phillips curve for two main reasons. First, he argued that like Keynesian economics in general, the Phillips curve ignored the supply side of the economy. In Friedman’s analysis, government policy that merely stimulates aggregate demand will inevitably create inflation unless there is also a policy to increase the supply side. Hence, free-market economists argue that if a government wishes to tackle unemployment it needs to remove obstacles to markets functioning properly, such as trade unions and unnecessary regulations, and to use low taxes and the profit motive to create incentives for workers and entrepreneurs.
The theoretical roots of this thinking rested in a fiscal policy that advocates low taxation and low welfare benefits. By creating incentives to work, the government can encourage workers to sell their labour at a competitive rate. Moreover, by allowing businesses to make profits, business leaders will invest in the economy and increase the capacity of the national capital stock. This will create more jobs and reduce inflation.
Economists now generally recognise that the Phillips curve in the diagram above is a short-run Phillips curve (SRPC), representing the short-run relationship between inflation and unemployment. In the next diagram, a vertical long-run Phillips curve (LRPC) has been added to the diagram, intersecting the short-run Phillips curve where the rate of inflation is zero. The rate of unemployment at this point is called the natural rate of unemployment (NRU), depicted by the symbol UN.
Once inflationary expectations have been allowed to develop, it is an extremely painful process to get workers to accept lower wages in the future. Indeed it may take a prolonged period of mass unemployment to discipline the labour markets and bleed the inflationary pay demands out of the economy.
Ultimately, a government can achieve economic growth with low inflation and reduce unemployment but only by tackling the long-term structural and supply-side problems in the economy. If a government is to shift the LRPC to the left (and the long-run aggregate supply curve to the right) it needs to pursue an investment strategy that enhances both the physical and human capital of an economy and reduces inflationary pressures. In the coming decades the UK economy is going to face increasing competition from overseas. British firms and workers will be unable to compete on cost but instead will have to offer services, production techniques and skills that cannot be easily replicated in other countries. A highly skilled workforce with the best capital equipment and technology is the objective that the government should aspire to if it is to reduce unemployment and maintain low inflation.
As is the case with the final part of a context data response question, the mark scheme for the second part (02) of an essay question is ‘level of skill based’. Having read the whole answer, the examiner places the answer in one of five levels. These are:
Level 1 — very weak
Level 2 — weak with some understanding
Level 3 — reasonable including some correct analysis but very limited evaluation
Level 4 — good analysis but limited evaluation or reasonable analysis and reasonable evaluation
Level 5 — good analysis and good evaluation
This answer is awarded 21 out of 25 marks and is placed at the top of level 4 in the mark scheme. The answer displays both good analysis and good evaluation, but does not quite reach level 5. It drifts a little too much into ‘write all you know about the Phillips curve’ and away from focusing on the issue posed by the question: ‘can governments reduce both the rate of inflation and the level of unemployment?’ The final paragraph relating to the supply-side of the economy is good, but added as a bit of an after-thought to the main part of the answer. It should appear, and be developed, much earlier in the answer.
Topic 2 Managing the national economy
2 The main fiscal objective of Chancellor George Osborne when coming to office in May 2010 was to eliminate the UK’s structural deficit and run a balanced budget by 2015. Due to poor economic data the Treasury later conceded that this could not be achieved until 2018. However, until June 2012 at least, the government’s tight fiscal policy (known variously as fiscal austerity, fiscal consolidation or fiscal realism) remains largely in place.
The government announced in March 2011 that it intended to cut government spending by £81 billion over a 4-year period. The main spending cuts would be achieved by cutting most of the government department budgets by up to 20%, although the NHS has been protected from any real cuts. The number of civil servants employed by the government has been dramatically reduced and 800,000 redundancies have been announced. Welfare benefits have been targeted by the Minister for Work and Pensions, Iain Duncan Smith, who wants to introduce a cap of £26,000 per year on benefit claimants. Public sector pay was frozen for 2 years and public sector pensions are in the process of being reformed to save money. The age for retirement has been increased to 67 and will rise to 68.
At the same time, levels of taxation have increased. The most significant is the increase in the VAT rate to 20%. The government first maintained the 50% income tax rate levied on top earners, but then cut the rate to 45%. Public sector pension contributions have been increased and tax bands have been lowered so that more workers have to pay the higher 40% band of taxation.
3 In the period between 1997 and 2006 the Labour Chancellor Gordon Brown was committed to the self-imposed Sustainable Investment Rule, which stated that the national debt would not rise above 40% of GDP. However, since 2007 the UK’s national debt has almost doubled and is expected to peak at 80% of GDP in 2014.
The causes of the rapid increase in the national debt are threefold. First, during the banking crisis of 2007/08 the British government nationalised the Northern Rock bank and partially nationalised RBS and HBOS. These bailouts kept the banks solvent but saw the British government accept liability for their massive debts. Second, the government ran up huge budget deficits after 2008. When the recession hit, tax revenues fell sharply but government spending increased, in part to prevent the collapse of the economy. Third, it is now clear that the British economy has been running a structural deficit and for too long the nation has lived beyond its means. Even in the good years, government spending was greater than tax revenues, which meant that in every year since 2002 the national debt increased. As a result, the current Chancellor is committed to a programme of spending cuts, with the long-term objective of bringing the budget deficit under control.
The national debt is significant for two reasons. First, it will have to be paid back by future taxpayers. This can only happen if future governments can get the economy to grow and run budget surpluses. Moreover, higher rates of taxation and lower levels of government welfare provision will reduce the standards of living for future generations. Second, an extremely high national debt will make it more difficult for the British government to borrow from international markets and will mean that the nation’s debt interest repayments will increase. Because of these problems (and although it does not admit it), the government will probably be quite happy to see inflation reduce the real value of the national debt.
4 The principle of equity is that a tax should be fair and that the tax is levied on those with the ability to pay the tax.
The principle of efficiency is that the tax should be easy to collect and that the government should not have to spend a disproportionate amount of money enforcing the collection of the tax.
5 Government intervention in the economy, which treats people in the same circumstances equally, obeys the principle of horizontal equity. Horizontal equity occurs when households with the same income and personal circumstances (for example, number of children) pay the same income tax and are eligible for the same welfare benefits. Vertical equity is much more controversial, since it justifies taking income from the rich (on the ground that they don’t need it) and redistributing their income to the poor (on the ground that they do need it). The distribution of income after taxation and receipt of transfers is judged more equitable than original income before redistribution.
Successful supply-side policies shift the LRAS curve to the right, increasing the economy’s natural level of real output from yN1 to yN2. The diagram also shows the price level falling (a benign deflation). However, it may be necessary for the AD curve also to shift to the right, to create the demand to absorb the extra output that successful supply-side policies produce. In this case, the price level may not fall.
8 The belief that control of inflation should be the primary economic objective of government can be traced back to the neo-liberal revolution, which started in the mid-1970s. Free-market economists argue that price stability is essential for long-term economic growth because it creates the necessary conditions for business confidence and private sector investment. If inflation is seen to be out of control, confidence is destroyed, businesses become uncertain and economic activity stagnates.
9 Until June 2012 at least, Bank Rate has remained at 0.5%, which is the lowest it has been since the Bank of England was founded in 1694.
10 Since 1997 the ‘official’ main target of monetary policy has been to ‘hit’ the inflation rate target set by the government. However, since the onset of recession in 2008 the Bank of England has set interest rates to stimulate aggregate demand. Low interest rates try to achieve this objective in two ways. First, households with large mortgages have been able to take advantage of the 0.5% rate and pay off debt. Second, saving has become unattractive and so, in theory at least, people decide to consume rather than save.
11 Quantitative easing (QE) is an unorthodox monetary policy, which since 2009 has been intermittently pursued by the Bank of England and the US Federal Reserve Bank. QE has been used to stimulate aggregate demand in order to encourage economic activity and thus to bring the economy out of deep recession and to prevent it re-entering recession.
A central bank operates QE by electronically creating new money in the central bank’s own current account. It uses this newly created electronic money to buy assets such as government bonds, equities, houses, corporate bonds or other assets from banks. The aim is to inject liquidity into the financial markets and push up asset prices by increasing demand for the assets. Higher bond prices cause bond yields, and hence long-run interest rates, to fall.
The hope is that as the banks sell assets to the central bank they have greater liquidity and receive deposits, which they in turn use to lend to businesses.
12 Since 1992, UK monetary policy has been ‘pre-emptive’. In pre-emptive monetary policy the authorities announce that they are prepared to raise interest rates even when there is no immediate sign of accelerating inflation, in order to anticipate and head-off a rise in the inflation rate that would otherwise occur many months later. The policy-makers at the Bank of England estimate what the inflation rate is likely to be 18 months to 2 years ahead (the medium term), if policy (that is, interest rates) remain unchanged. If the forecast rate of inflation is different from the target rate set by the government, the Bank changes interest rates to prevent the forecast inflation rate becoming a reality in the future. Interest rates are also raised or lowered to pre-empt any likely adverse effect upon the inflation rate of an adverse ‘outside shock’ hitting the economy.
However, following the near meltdown of the UK economy in 2008 and in response to the deep recession of 2009, it is fair to say that for a time at least, British monetary policy became reactive rather than pre-emptive. This means that interest rates are set (and further bouts of QE are introduced), not so much with the medium-term future in mind, but in reaction to falling national output (in the recession) and growing unemployment.
13 An international capital flow is defined as the movement of money for the purpose of investment or speculation between countries. It involves selling one currency and buying the currency of the country into which the flow of funds is moving.
In recent decades a form of international capital flow known as a speculative ‘hot money’ has grown in significance. A ‘hot money’ flow occurs when a very rich person or institution decides to switch funds between currencies. A factor influencing these flows is interest rate differences in different countries. Suppose for example the Bank of England cuts Bank Rate to a rate significantly below dollar or euro interest rates. In response to Bank Rate falling, owners of ‘hot money’ sell the pound and buy dollars and euros so as to benefit from the higher return on these currencies. The selling of pounds causes the pound’s exchange rate to fall. Hot money flows are speculative in the sense that owners of hot money also move funds into currencies whose exchange rates the speculators believe are going to rise.
In the diagram the supply of sterling has increased as speculators have sold their stocks of sterling. They have moved their ‘hot money’ out of sterling and into another currency with the effect of shifting the supply curve to the right. This causes the pound’s exchange rate to fall, thus devaluing sterling.
15 A fall in the exchange rate should make UK exports price competitive in international markets and increase the demand for them. This should reduce unemployment. However, the fall in the value of the currency will increase the price of imports, which will lead to import-cost-push inflation in the UK.