Category: Economics 9e: Ch 21

On 8 February, the Bank of England issued a statement that was seen by many as a warning for earlier and speedier than previously anticipated increases in the UK base rate. Mark Carney, the governor of the Bank of England, referred in his statement to ‘recent forecasts’ which make it more likely that ‘monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November report’.

A similar picture emerges on the other side of the Atlantic. With labour markets continuing to deliver spectacularly high rates of employment (the highest in the last 17 years), there are also now signs that wages are on an upward trajectory. According to a recent report from the US Bureau of Labor Statistics, US wage growth has been stronger than expected, with average hourly earnings rising by 2.9 percent – the strongest growth since 2009.

These statements have coincided with a week of sharp corrections and turbulence in the world’s largest capital markets, as investors become increasingly conscious of the threat of rising inflation – and the possibility of tighter monetary policy.

The Dow Jones plunged from an all-time high of 26,186 points on 1 February to 23,860 a week later – losing more than 10 per cent of its value in just five trading sessions (suffering a 4.62 percentag fall on 5 February alone – the worst one-day point fall since 2011). European and Asian markets followed suit, with the FTSE-100, DAX and NIKKEI all suffering heavy losses in excess of 5 per cent over the same period.

But why should higher inflationary expectations fuel a sell-off in global capital markets? After all, what firm wouldn’t like to sell its commodities at a higher price? Well, that’s not entirely true. Investors know that further increases in inflation are likely to be met by central banks hiking interest rates. This is because central banks are unlikely to be willing or able to allow inflation rates to rise much above their target levels.

The Bank of England, for instance, sets itself an inflation target of 2%. The actual ongoing rate of inflation reported in the latest quarterly Inflation Report is 3% (50 per cent higher than the target rate).

Any increase in interest rates is likely to have a direct impact on both the demand and the supply side of the economy.

Consumers (the demand side) would see their cost of borrowing increase. This could put pressure on households that have accumulated large amounts of debt since the beginning of the recession and could result in lower consumer spending.

Firms (the supply side) are just as likely to suffer higher borrowing costs, but also higher operational costs due to rising wages – both of which could put pressure on profit margins.

It now seems more likely that we are coming towards the end of the post-2008 era – a period that saw the cost of money being driven down to unprecedentedly low rates as the world’s largest economies dealt with the aftermath of the Great Recession.

For some, this is not all bad news – as it takes us a step closer towards a more historically ‘normal’ equilibrium. It remains to be seen how smooth such a transition will be and to what extent the high-leveraged world economy will manage to keep its current pace, despite the increasingly hawkish stance in monetary policy by the world’s biggest central banks.


Global Markets Shed $5.2 Trillion During the Dow’s Stock Market Correction Fortune, Lucinda Shen (9/2/18)
Bank of England warns of larger rises in interest rates Financial Times, Chris Giles and Gemma Tetlow (8/2/18)
Stocks are now in a correction — here’s what that means Business Insider, Andy Kiersz (8/2/18)
US economy adds 200,000 jobs in January and wages rise at fastest pace since recession Business Insider, Akin Oyedele (2/2/18)


Dow plunges 1,175 – worst point decline in history CNN Money, Matt Egan (5/2/18)


  1. Using supply and demand diagrams, explain the likely effect of an increase in interest rates to equilibrium prices and output. Is it good news for investors and how do you expect them to react to such hikes? What other factors are likely to influence the direction of the effect?
  2. Do you believe that the current ultra-low interest rates could stay with us for much longer? Explain your reasoning.
  3. What is likely to happen to the exchange rate of the pound against the US dollar, if the Bank of England increases interest rates first?
  4. Why do stock markets often ‘overshoot’ in responding to expected changes in interest rates or other economic variables

The UK is a productivity laggard. Compared to many developed countries over the recent past it has experienced weaker growth in output per worker and output per hour worked. This is detrimental to our longer-term well-being and to peoples’ living standards. An important contributory factor has been the weakness of growth in (non-financial) capital per worker. Recent ONS figures show that UK experienced a decline in capital per worker from 2012 to 2015, which was only ended in 2016.

Non-financial capital assets (also known as fixed assets) are defined as already-produced, durable goods or any non-financial asset used in the production of goods or services. This includes items such as dwellings, buildings, ICT, machinery and transport equipment.

Chart 1 shows the value of net capital assets in the UK since 1995. ‘Net’ figures account for the depreciation of assets and so reflect the market value of the capital stock. At the end of 2016 the net capital stock was estimated at £7.54 trillion (at 2015 prices) compared to £4.94 trillion (at 2015 prices) in 1995, an increase of 53 per cent or about 2.4 per cent per year.

However, as the chart shows, the rate of growth slowed markedly following the financial crisis of the late 2000s, averaging a mere 0.8 per cent per year since 2010. (Click here for a Powerpoint of the chart).

Capital intensity can be measured by the amount of capital per employee. Capital intensity is important because the growth in net capital per employee impacts on productivity. Its growth has an impact on the current effectiveness of capital and labour in production and on the future growth in potential output per employee.

Chart 2 shows that, following the financial crisis, falling employment levels temporarily boosted the growth in net capital per employee. Then, as employment levels recovered and began growing again, the weakness in investment meant that net capital per employee began to fall.

In 2016, as employment growth slowed, the now stronger flows of investment meant that, for the first time since 2011, net capital per employee was finally rising again. (Click here for a PowerPoint of the chart).

The persistent weakness experienced by UK in the growth of capital intensity in the 2010s is a drag on productivity and on supply-side growth. The weakness of UK productivity growth looks like remaining for some time one of the biggest economic challenges facing policymakers. Productivity needs its capital.


UK business investment on ice until more Brexit progress, warns BCC The Guardian, Richard Partington (11/12/17)
Budget 2017: Can Digital Plug The UK’s Productivity Gap? Hufttington Post, William Newton (27/11/17)
UK productivity estimates must be ‘significantly’ lowered, admits OBR The Guardian, Richard Partington and Phillip Inman (13/12/17)
UK productivity sees further fall BBC News (6/10/17)


Capital stocks, consumption of fixed capital in the UK: 2017 ONS


  1. How might we measure productivity?
  2. Compose a list of items that are examples of non-financial (or fixed) capital.
  3. How can the growth of non-financial (or fixed) capital affect productivity?
  4. What is meant by capital intensity? Why is this concept important for long-term growth?
  5. What factors might affect the rate of capital accumulation? Are there interventions that governments can make to impact on the rate of capital accumulation?
  6. Discuss the possible reasons why the UK has become a productivity laggard.

In delivering his Budget on 22 November, Philip Hammond reported that the independent Office for Budget Responsibility had revised down its forecasts of growth in productivity and real GDP, and hence of earnings growth.

Today, median earnings are £23,000 per annum. This is £1500 less than the £24,500 that the median worker earned in 2008 in today’s prices. The OBR forecasts a growth in real household disposable income of just 0.35% per annum for the next four years.

With lower growth in earnings would come a lower growth in tax revenues. With his desire to cut the budget deficit and start eventually reducing government debt, this would give the government less scope for spending on infrastructure, training and other public-sector investment; less scope to support public services, such as health and education; less scope for increasing benefits and public-sector wages.

The normal measure of productivity, and the one used by the OBR, is the value of output produced per hour worked. This has hardly increased at all since the financial crisis of 2008. It now takes an average worker in the UK approximately five days to produce the same amount as it takes an average worker in Germany four days. Although other countries’ productivity growth has also slowed since the financial crisis, it has slowed more in the UK and from a lower base – and is now forecast to rebound less quickly.

For the past few years the OBR has been forecasting that productivity growth would return to the trend rate of just over 2% that the UK achieved prior to 2008. For example, the forecasts it made in June 2010 are shown by the grey line in the chart, which were based on the pre-crash trend rate of growth in productivity (click on chart to enlarge). And the forecasts it made in November 2016 are shown by the pale green line. Yet each year productivity has hardly changed at all. Today output per hour is less than 1% above its level in 2008.

Now the OBR believes that poorer productivity growth will persist. It is still forecasting an increase (the blue line in the chart) – but by 0.7 of a percentage point less than it was forecasting a year ago (the pale green line): click here for a PowerPoint of the chart.

We have assumed that productivity growth will pick up a little, but remain significantly lower than its pre-crisis trend rate throughout the next five years. On average, we have revised trend productivity growth down by 0.7 percentage points a year. It now rises from 0.9 per cent this year to 1.2 per cent in 2022. This reduces potential output in 2021-22 by 3.0 per cent. The ONS estimates that output per hour is currently 21 per cent below an extrapolation of its pre-crisis trend. By the beginning of 2023 we expect this to have risen to 27 per cent.

Why has there been such weak productivity growth?
Weak productivity growth has been caused by a mixture of factors.

Perhaps the most important is that investment as a percentage of GDP has been lower than before the financial crisis and lower than in other countries. Partly this has been caused by a lack of funding for investment as banks have sought to rebuild their capital and have cut down on riskier loans. Partly it has been caused by a lack of demand for investment, given sluggish rates of economic growth and the belief that austerity will continue.

And it is not just private investment. Public-sector investment in transport infrastructure, housing and education and training has been lower than in other countries. Indeed, the poor training record and low skill levels in the UK are main contributors to low productivity.

The fall in the pound since the Brexit vote has raised business costs and further dampened demand as incomes have been squeezed.

Another reason for low productivity growth has been that employers have responded to weak demand, not by laying off workers and thereby raising unemployment, but by retaining low-productivity workers on low wages. Another has been the survival of ‘zombie’ firms, which, by paying low wages and facing ultra-low interest rates, are able to survive competition from firms that do invest.

Why is weak productivity growth forecast to continue?
Looking forward, the nature of the Brexit deal will impact on confidence, investment, wages and growth. If the deal is bad for the UK, the OBR’s forecasts are likely to be too optimistic. As it is, uncertainty over the nature of the post-Brexit world is weighing heavily on investment as some businesses choose to wait before committing to new investment.

On the other hand, exports may rise faster as firms respond to the depreciation of the pound and this may stimulate investment, thereby boosting productivity.

Another factor is the effect of continuing tight Budgets. There was some easing of austerity in this Budget, as the Chancellor accepted a slower reduction in the deficit, but government spending will remain tight and this is likely to weigh on growth and investment and hence productivity.

But this may all be too gloomy. It is very difficult to forecast productivity growth, especially as it is hard to measure output in much of the service sector. It may be that the productivity growth forecasts will be revised up before too long. For example, the benefits from new technologies, such as AI, may flow through more quickly than anticipated. But they may flow through more slowly and the productivity forecasts may have to be revised down even further!


The OBR’s productivity “forecast” Financial Times, Kadhim Shubber
U.K. Faces Longest Fall in Living Standards on Record Bloomberg, Simon Kennedy and Thomas Penny (23/11/17)
Britain’s Productivity Pain Costs Hammond $120 Billion Bloomberg, Fergal O’Brien (22/11/17)
OBR slashes Britain’s growth forecast on sluggish productivity and miserly pay The Telegraph, Tim Wallace (22/11/17)
Budget 2017: Stagnant earnings forecast ‘astonishing’ BBC News (23/11/17)
Economists warn Budget measures to lift productivity fall short Financial Times, Gavin Jackson and Gill Plimmer (22/11/17)
Why the economic forecasts for Britain are so apocalyptic – and how much Brexit is to blame Independent, Ben Chu (24/11/17)
Growth holds steady as economists doubt OBR’s gloom The Telegraph, Tim Wallace (23/11/17)
Britain’s debt will not fall to 2008 levels until 2060s, IFS says in startling warning Independent, Lizzy Buchan (23/11/17)
Philip Hammond’s budget spots Britain’s problems but fails to fix them The Economist (22/11/17)
Debunking the UK’s productivity problem The Conversation, Paul Lewis (24/11/17)
Budget 2017: experts respond The Conversation (22/11/17)
Autumn Budget 2017 Forecasts Mean ‘Longest Ever Fall In Living Standards’, Says Resolution Foundation Huffington Post, Jack Sommers (23/11/17)
It May Just Sound Like A Statistic, But Productivity Growth Matters For All Of Us Huffington Post, Thomas Pope (24/11/17) (see also)
UK prospects for growth far weaker than first predicted, says OBR The Guardian, Angela Monaghan (22/11/17)
UK faces two decades of no earnings growth and more austerity, says IFS The Guardian, Phillip Inman (23/11/17)
Age of austerity isn’t over yet, says IFS budget analysis The Guardian, Larry Elliott (23/11/17)

Summary of Budget measures

Budget 2017: FT experts look at what it means for you Financial Times (24/11/17)

Official Documents

Autumn Budget 2017 HM Treasury (22/11/17)
Economic and fiscal outlook – November 2017 Office for Budget Responsibility (22/11/17)

IFS analysis

Autumn Budget 2017 Institute for Fiscal Studies (23/11/17)


  1. What measures of productivity are there other than output per hour? Why is output per hour normally the preferred measure of productivity?
  2. What factors determine output per hour?
  3. Why have forecasts of productivity growth rates been revised downwards?
  4. What are the implications of lower productivity growth for government finances?
  5. What could cause an increase in output per hour? Would there be any negative effects from these causes?
  6. What policies could the government pursue to increase productivity? How feasible are these policies? Explain.
  7. Would it matter if the government increased borrowing substantially to fund a large programme of public investment?

On 2 November, the Bank of England raised Bank rate from 0.25% to 0.5% – the first rise since July 2007. But was now the right time to raise interest rates? Seven of the nine-person Monetary Policy Committee voted to do so; two voted to keep Bank Rate at 0.25%.

Raising the rate, on first sight, may seem a surprising decision as growth remains sluggish. Indeed, the two MPC members who voted against the rise argued that wage growth was too weak to justify the rise. Also, inflation is likely to fall as the effects of the Brexit-vote-induced depreciation of sterling on prices feeds through the economy. In other words, prices are likely to settle at the new higher levels but will not carry on rising – at least not at the same rate.

So why did the other seven members vote to raise Bank Rate. There are three main arguments:

Inflation, at 3%, is above the target of 2% and is likely to stay above the target if interest rates are not raised.
There is little spare capacity in the economy, with low unemployment. There is no shortage of aggregate demand relative to output.
With productivity growth being negligible and persistently below that before the financial crisis, aggregate demand, although growing slower than in the past, is growing excessively relative to the growth in aggregate supply.

As the Governor stated at the press conference:

In many respects, the decision today is straightforward: with inflation high, slack disappearing, and the economy growing at rates above its speed limit, inflation is unlikely to return to the 2% target without some increase in interest rates.

But, of course, the MPC’s forecasts may turn out to be incorrect. Many things are hard to predict. These include: the outcomes of the Brexit negotiations; consumer and business confidence and their effects on consumption and investment; levels of growth in other countries and their effects on UK exports; and the effects of the higher interest rates on saving and borrowing and hence on aggregate demand.

The Bank of England is well aware of these uncertainties. Although it plans two more rises in the coming months and then Bank Rate remaining at 1% for some time, this is based on its current assessment of the outlook for the economy. If circumstances change, the Bank will adjust the timing and total amount of future interest rate changes.

There are, however, dangers in the rise in interest rates. Household debt is at very high levels and, although the cost of servicing these debts is relatively low, even a rise in interest rates of just 0.25 percentage points can represent a large percentage increase. For example, a rise in a typical variable mortgage interest rate from 4.25% to 4.5% represents a 5.9% increase. Any resulting decline in consumer spending could dent business confidence and reduce investment.

Nevertheless, the Bank estimates that the effect of higher mortgage rates is likely to be small, given that some 60% of mortgages are at fixed rates. However, people need to refinance such rates every two or three years and may also worry about the rises to come promised by the Bank.


Bank of England deputy says interest rate rise means pain for households and more hikes could be in store Independent, Ben Chapman (3/11/17)
UK interest rates: Bank of England shrugs off Brexit nerves to launch first hike in over a decade Independent, Ben Chu (2/11/17)
Bank of England takes slow lane after first rate hike since Reuters, David Milliken, William Schomberg and Julian Satterthwaite (2/11/17)
First UK rate rise in a decade will be a slow burn Financial Times, Gemma Tetlow (2/11/17)
The Bank of England’s Rate Rise Could Spook Britain’s Economy Bloomberg, Fergal O’Brien and Brian Swint (3/11/17)
Bank of England hikes rates for the first time in a decade CNBC, Sam Meredith (2/11/17)
Interest rates rise in Britain for the first time in a decade The Economist (2/11/17)

Bank of England publications

Bank of England Inflation Report Press Conference, Opening Remarks Financial Times on YouTube, Mark Carney (2/11/17)
Bank of England Inflation Report Press Conference, Opening Remarks Bank of England, Mark Carney (2/11/17)
Inflation Report Press Conference (full) Bank of England on YouTube (2/11/17)
Inflation Report Bank of England (November 2017)
Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 1 November 2017 Bank of England (2/11/17)


  1. Why did the majority of MPC members feel that now was the right time to raise interest rates whereas a month ago was the wrong time?
  2. Why did the exchange rate fall when the announcement was made?
  3. How does a monetary policy of targeting the rate of inflation affect the balance between aggregate demand and aggregate supply?
  4. Can monetary policy affect potential output, or only actual output?
  5. If recent forecasts have downgraded productivity growth and hence long-term economic growth, does this support the argument for raising interest rates or does it suggest that monetary policy should be more expansionary?
  6. Why does the MPC effectively target inflation in the future (typically in 24 months’ time) rather than inflation today? Note that Mark Carney at the press conference said, “… it isn’t so much where inflation is now, but where it’s going that concerns us.”
  7. To what extent can the Bank of England’s monetary policy be described as ‘discretionary’?

In three interesting articles, linked below, the authors consider the state of economies since the financial crisis of 2007–8 and whether governments have the right tools to tackle future economic shocks.

There have been some successes over the past 10 years, in particular keeping inflation close to central bank targets despite considerable shocks (see the Vox article). Also unemployment has fallen in most countries and to very low levels in some, including the UK.

But economic growth has generally remained well below the levels prior to the financial crisis, with low productivity growth being the main culprit. Indeed, many people have seen no growth at all in their real incomes over the past 10 years, with low unemployment being bought at the cost of a growth in zero-hour contracts and work in the gig economy. And what economic growth we have seen has been largely the result of taking up slack through unprecedentedly loose monetary policy.

Fiscal policy, except in the period directly following the financial crisis, has generally been tight as governments have sought to reduce their deficits and slow down the growth in their debt.

But what will happen if economies once more slow? Or, worse still, what will happen if there is another global recession? Do countries have the policies to tackle the problem this time round?

Quantitative easing could be used again, but many economists believe that it will have more limited scope if confined to the purchase of assets in the secondary market. Also, there is little scope for reducing interest rates, which, despite some modest rises in the USA, remain at close to zero in most developed countries.

One possibility is a combination of monetary and fiscal policy, where new money is used to finance government expenditure on infrastructure, such as road and rail, broadband, green energy, hospitals and schools and colleges. This would avoid the need for governments to borrow on open markets as the spending would be financed by new government securities purchased directly by the central bank.

An objection to such ‘people’s quantitative easing‘, as it has been dubbed, is that it would effectively end the independence of central banks. This independence has been credited by many with giving central banks credibility in controlling inflation. Would inflationary expectations rise with people’s quantitative easing and, with it, actual inflation? A lot would depend on the extent to which this QE could still be conducted within a framework of targeting inflation and whether people’s expectations of inflation could be managed jointly by the government and central bank.


How should recessions be fought when interest rates are low? The Economist. Free exchange (21/10/17)
The economy is failing. We need to think radically about how to fix it The Guardian, Liam Byrne (25/10/17)
Elusive inflation and the Great Recession Vox, David Miles, Ugo Panizza, Ricardo Reis, Ángel Ubide (25/10/17)


Economics since the crisis Vox on YouTube. Charles Goodhart (11/10/17)
Is the system broken? Vox on YouTube, Anat Admati (12/10/17)
Signs of a crisis Vox on YouTube, Christian Thimann (19/10/17)
Policy stances since 2007 Vox on YouTube, Paul Krugman (29/10/17)
Did policymakers get it right? Vox on YouTube, Paul Krugman (4/10/17)


  1. Why, during the next recession, will the “zero lower bound” (ZLB) on interest rates almost certainly bite again?
  2. Why would the scope for QE, as conducted up to now, be more limited in the future if a recession were to occur?
  3. Why have central banks appeared to have been so successful in keeping inflation close to target despite negative and positive demand- and supply-side shocks?
  4. Why are the pressures on government expenditure likely to increase in the coming years?
  5. How would a temporary price-level target help to tackle a recession when the economy next bumps into the ZLB? What would limit its success?
  6. Is it appropriate for central banks to stick to an inflation target in times when there is an adverse supply-side shock resulting in cost-push inflation?
  7. Why might monetary policy conducted in a framework of inflation targeting tend to lessen the impact of a fiscal stimulus?
  8. What are the arguments for and against relaxing central bank independence and pursuing a co-ordinated fiscal and monetary policy?
  9. What are the arguments for and against using helicopter money to boost private expenditure during a future recession where interest rates are already near the ZLB?
  10. What are the arguments for and against using ‘people’s QE’?