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Posts Tagged ‘external shocks’

Economic shocks and the Ukrainian crisis

One of the reasons why it is so hard to forecast economic growth and other macroeconomic indicators is that economies can be affected by economic shocks. Sometimes the effects of shocks are large. The problem with shocks is that, by their very nature, they are unpredictable or hard to predict.

A case in point is the current crisis in Ukraine. First there was the uprising in Kiev, the ousting of President Yanukovich and the formation of a new government. Then there was the seizing of the Crimean parliament by gunmen loyal to Russia. The next day, Saturday March 1, President Putin won parliamentary approval to invade Ukraine and Russian forces took control of the Crimea.

On Monday 3 March, stock markets fell around the world. The biggest falls were in Russia (see chart). In other stock markets, the size of the falls was directly related to the closeness of trade ties with Russia. The next day, with a degree of calm descending on the Crimea and no imminent invasion by Russia of other eastern parts of Ukraine, stock markets rallied.

What will happen to countries’ economies depends on what happens as the events unfold. There could be a continuing uneasy peace, with the West effectively accepting, despite protests, the Russian control of the Crimea. But what if Russia invades eastern Ukraine and tries to annex it to Russia or promote its being run as a separate country? What if the West reacted strongly by sending in troops? What if the reaction were simply sanctions? That, of course would depend on the nature of those sanctions.

Some of the possibilities could have serious effects on the world economy and especially the Russian economy and the economies of those with strong economic ties to Russia, such as those European countries relying heavily on gas and oil imports from Russia through the pipeline network.

Economists are often criticised for poor forecasts. But when economic shocks can have large effects and when they are hard to predict by anyone, not just economists, then it is hardly surprising that economic forecasts are sometimes highly inaccurate.

What Wall Street is watching in Ukraine crisis USA Today (3/3/14)
Ukraine’s economic shock waves – magnitude uncertain Just Auto, Dave Leggett (7/3/14)
Ukraine: The end of the beginning? The Economist (8/3/14)
Russia will bow to economic pressure over Ukraine, so the EU must impose it The Guardian, Guy Verhofstadt (6/3/14)
Russia paying price for Ukraine crisis CNN Money, Mark Thompson (6/3/14)
Ukraine Crimea: Russia’s economic fears BBC News, Nikolay Petrov (7/3/14)
How Russia’s conflict with Ukraine threatens vital European trade links The Telegraph, Szu Ping Chan (8/3/14)
Will a Russian invasion of Ukraine push the west into an economic war? Channel 4 News, Paul Mason (2/3/14)
Who loses from punishing Russia? BBC News, Robert Peston (4/3/14)
Should Crimea be leased to Russia? BBC News, Robert Peston (7/3/14)
The Ukraine Economic Crisis Counter Punch, Jack Rasmus (7-9/3/14)
UK price rise exposes failure to prepare for food and fuel shocks The Guardian, Phillip Inman (2/3/14)

Questions

  1. What sanctions could the West realistically impose on Russia?
  2. How would sanctions against Russia affect (a) the Russian economy and (b) the economies of those applying the sanctions?
  3. Which industries would be most affected by sanctions against Russia?
  4. Is Russia likely to bow to economic pressure from the West?
  5. Should Crimea be leased to Russia?
  6. Is the behaviour of stock markets a good indication of people’s expectations about the real economy?
  7. Identify some other economic shocks (positive and negative) and their impact.
  8. Could the financial crisis of 2007/8 be described as an economic shock? Explain.
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Wisdom of hindsight

Every quarter, the Bank of England publishes its Inflation Report. This analyses developments in the macroeconomy and gives forecasts for inflation and GDP growth over the following 12 quarters. It is on the forecast for inflation in 8 quarters’ time that the Bank of England’s Monetary Policy Committee primarily bases its interest rate decision.

According to the February 2011 Inflation Report forecast, CPI inflation is expected to be at or slightly below its 2% target in two year’s time, but there is considerable uncertainty about this, as shown in the fan diagram in Chart 3 of the Overview. What is more, inflation is likely to rise considerably before it falls back. As the Report states:

CPI inflation is likely to pick up to between 4% and 5% in the near term and to remain well above the 2% target over the next year or so, reflecting in part the recent increase in VAT. The near-term profile is markedly higher than in November, largely reflecting further rises in commodity and import prices since then. Further ahead, inflation is likely to fall back, as those effects diminish and downward pressure from spare capacity persists. But both the timing and extent of that decline in inflation are uncertain.

It is interesting to look back at the Inflation Reports of a year ago and two years ago to see what was being forecast then and to compare them with what has actually happened. It’s not too difficult to explain why the forecasts have turned out to be wrong. Hindsight is a wonderful thing. Unfortunately, foresight is less wonderful.

Articles
BoE forecasts pave way to rate rise, but King cautious Reuters, Matt Falloon and Fiona Shaikh (16/2/11)
Inflation report: what the economists say Guardian (16/2/11)
Inflation will rise sharply, says Mervyn King BBC News (16/2/11)
The unrepentant governor BBC News blogs: Stephanomics, Stephanie Flanders (16/2/11)
Inflation: Mervyn and me BBC News blogs: Idle Scrawl, Paul Mason (16/2/11)
What would Milton do? The Economist, Buttonwood (16/2/11)
Why inflation hawks are still grounded Fortune, Colin Barr (16/2/11)

Podcast and Webcast
Bank of England Press conference: Podcast (16/2/11)
Bank of England Press conference: Webcast (16/2/11)

Inflation Report
Inflation Report, portal page for latest report and sections, Bank of England
Inflation Report, February 2011: full report, Bank of England

Data
Forecasts for the UK economy: a comparison of independent forecasts, HM Treasury
Prospects for the UK economy, National Institute of Economic and Social Research press release (1/2/11)
Output, Prices and Jobs, The Economist (10/2/11)

Questions

  1. Examine the forecasts for UK inflation and GDP for 2010 made in the February 2009 and February 2010 Bank of England Inflation Reports. How accurate were they?
  2. Explain the difference between the forecasts and the outturn.
  3. Why is it particularly difficult to forecast inflation and GDP growth at the present time for two years hence?
  4. What are the advantages of the Bank of England using a forward-looking rule as opposed to basing interest rate decisions solely on current circumstances?
  5. Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
  6. What do you understand by the term ‘core’ inflation? Is this the same thing as demand-pull inflation?
  7. How is the Bank of England’s policy on interest rates likely to affect expectations? What expectations are particularly important here?
  8. Explain whether or not it is desirable for interest rates to be adjusted in response to external shocks, such as commodity price increases?
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