Category: Economics for Business: Ch 29

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Rates down Down Under

Australia was one of the few economies that seemed to be somewhat insulated from the 2008/09 recession and credit crunch. However, with the UK now back in recession and global economic conditions worsening in much of Europe, Australia has now joined the list of countries that are experiencing economic conditions that are ‘weaker than forecast’.

Today’s world involves economies that are increasingly interdependent, hence the spread of the world economic slowdown. As such, with weak global demand, Australia has started to feel the effects, with demand for its goods and raw materials falling. This has led Australia’s central bank – the Reserve Bank of Australia – to cut its key interest rate (the ‘cash rate’) by more than expected. The rate had been at 4.25% and it was widely believed that a 0.25 percentage point cut would occur. However, the central bank cut the cash rate rate to 3.75% to counter the weakening conditions. The Reserve Bank said:

“This decision is based on information received over the past few months that suggests that economic conditions have been somewhat weaker than expected, while inflation has moderated …Growth in the world economy slowed in the second half of 2011, and is likely to continue at a below-trend pace this year.”

Banks’ interest rates have been falling in Australia for the past few months and this latest cut will do much to help financially squeezed households. Data show that Australian house sales have fallen, as have house prices, and retail sales have fared little better.

Lower interest rates are often a tool used to steer inflation and the Australian central bank may not have been as willing to cut rates had the inflation rate not come down in recent months. Keeping consumer prices under control remains a top priority for the central bank and so it will be interesting to see the impact that these rate cuts will have on the Australian economy.

Articles

Australia cenbank surprises with aggressive half point rate cut Reuters, Wayne Cole (1/5/12)
Australia cuts rates by than forecast to 3.75% BBC News (1/5/12)
Banks unlikely to pass on full rate cut The Australian, Wall Street Journal, Peter Trute (1/5/12)
Australia cuts rate to support economy Financial Times, Neil Hume (1/5/12)
Australia slashes interest rates by 0.5pc to boost economy The Telegraph (1/5/12)
Australia cuts interest rates as economy slows Guardian, Phillip Inman (1/5/12)
Banks must pass on rate cut: businesses Sydney Morning Herald, Ehssan Veiszadeh (1/5/12)
Bond prices rally after rate cut Sydney Morning Herald (1/5/12)
Surplus remains appropriate: Swan Sydney Morning Herald, Colin Brinsden (1/5/12)

Webcasts

Reserve Bank of Australia Cuts Rates by 50 Basis Points to 3.75% CNBC video, Lauren Rosborough (1/5/12)
Further `Modest’ RBA Easing Possible, ANZ Says Bloomberg, Tony Morriss (1/5/12)
Australia’s central bank shifts focus to growth BBC News, Duncan Kennedy (1/5/12)

Questions

  1. Which factors will a central bank consider when setting interest rates?
  2. Explain the components of aggregate demand that will be affected by a lower rate of interest.
  3. Using diagrams to illustrate the process, explain both the interest-rate and the exchange-rate transmission mechanisms of the fall in interest rates.
  4. How are interest rates used to target inflation?
  5. How will lower rates of interest help the Australian economy recover from weakening global economic conditions?
  6. Why are Australia’s banks unlikely to pass on the full rate cut to consumers?
  7. Why did bond prices rise and the Australian dollar depreciate after the rate cut? Why does this suggest that a 0.5% cut was greater than anticpated by markets?
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Roller coaster ride: or just bumping along the bottom?

The UK is officially back in recession: or to be more accurate, a double-dip recession.

The generally accepted definition of a recession is two or more quarters of negative growth in real GDP. According to figures released by the Office for National Statistics, the UK economy shrank by 0.2% in quarter 1, 2012, having shrunk by 0.3% in quarter 4, 2011.
(Click on the following link for a PowerPoint of the above chart: Double dip 2)

As you can see from the chart (click chart for a larger version), these declines are tiny compared with the recession of 2008/9. Nevertheless, with the eurozone economy slowing (Britain’s largest export market), and with cuts to government expenditure set to bite harder in the coming months, there are worries that there may be more quarters of negative growth to come.

So what are the causes of this double-dip recession? Are they largely external, in terms of flagging export markets; or are they internal? Is the new recession the direct result of the tight fiscal policy pursued by the Coalition government?

And what is to be done? Is there no option but to continue with the present policy – the government’s line? Or should the austerity measures be reined in? After all, as we saw in the last blog post (Economic stimulus, ‘oui’; austerity, ‘non’), the mood in many European countries is turning against austerity.

The following articles explore the causes and policy implications of the latest piece of bad news on the UK economy.

Articles
Double-dip recession a terrible blow for George Osborne Guardian, Larry Elliott (25/4/12)
Double-dip recession figures mark another bad day for George Osborne Guardian, Larry Elliott (25/4/12)
UK double-dip recession: what the economists say Guardian (25/4/12)
Feared double dip recession becomes reality as British economy contracts again in first quarter of 2012 Daily Record (25/4/12)
Britain in double-dip recession as growth falls 0.2pc The Telegraph, Angela Monaghan and Szu Ping Chan (25/4/12)
Did the eurozone crisis cause the double-dip recession? Guardian, Polly Curtis (25/4/12)
UK’s double-dip recession Financial Times, Chris Giles (25/4/12)
UK is in ‘double dip’ recession FT Adviser, Rebecca Clancy and John Kenchington (25/4/12)
Flanders explains GDP figure BBC News, Stephanie Flanders (25/4/12)
No recovery for UK: No let up for ONS BBC News, Stephanie Flanders (25/4/12)
Double-dip recession: There’s always fantasy island BBC News, Paul Mason (25/4/12)
UK double-dip recession to drag on into summer, economists warn The Telegraph, Philip Aldrick (26/4/12)
George Osborne can stop the rot, but only by spending as he slashes The Telegraph, Jeremy Warner (25/4/12)
Double dip has arrived – and Osborne is running out of escape routes Independent, Ben Chu (26/4/12)
Britain’s bosses tell the ONS: it’s bad, but not a recession Independent, Tom Bawden, Lucy Tobin , Gideon Spanier (26/4/12)
The Chancellor received plenty of warning Independent, David Blanchflower (26/5/12)

Data

Gross Domestic Product: Preliminary Estimate, Q1 2012 ONS (25/4/12)
Preliminary Estimate of GDP Time Series Dataset 2012 Q ONS (25/4/12)
World Economic Outlook Database IMF (17/4/12)
Business and Consumer Surveys (for all individual EU countries and for the EU as a whole) European Commission: Economic and Financial Affairs
Consumer Confidence Nationwide Building Society

Questions

  1. Assess the current state of the UK economy and its likely course over the coming few months.
  2. Why may looking at the business surveys provide a truer picture of the state of the UK economy than the official measure of GDP?
  3. Why has the UK economy gone back into recession?
  4. Compare the policy approaches of the Coalition government with those of the Labour opposition.
  5. How important is it for the UK to retain its AAA credit rating?
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Little cheer in forecasts for consumer spending

A crucial determinant of the economy’s short-term prospects is the appetite of households for spending. This is because household spending makes up roughly two-thirds of the total demand for firms’ goods and services or two-thirds of what economists refer to as aggregate demand. So what are the latest forecasts for consumer spending? We briefly consider the forecasts of the Office for Budget Responsibility for consumer spending and, in doing so, update an earlier bog Gloomy prospects for spending in 2012?

In its March 2012 Economic and Fiscal Outlook the Office for Budget Responsibility presents it forecasts for economic growth and household spending. The following table summarises these forecasts.

OBR Forecasts (annual real percentage change)

2012 2013 2014 2015 2016
GDP 0.8 2.0 2.7 3.0 3.0
Consumption 0.5 1.3 2.3 3.0 3.0
Disposable income –0.2   0.5 1.9 2.4 2.5

Source: Economic and Fiscal Outlook (Table 3.6) (Office for Budget Responsibility)

The OBR are forecasting that household spending will increase in real terms in 2012 by 0.5 per cent and by a further 1.3 per cent in 2013. This is on the back of a fall in real consumption in 2011 of 1.2 per cent. Therefore, the rebound in consumer spending is predicted to be only fairly modest. The long-term average annual real increase in household spending is around 2½ per cent.

The drag on consumer spending growth remains the weakness of growth in real disposable income. The post-tax income of the household sector fell in real terms by 1.2 per cent in 2011 and is expected to fall by a further 0.2 per cent in 2012. It is not until 2015 that growth in real disposable income returns to its long-term average which, unsurprisingly, is roughly the same as that of household sector spending.

As we noted in our earlier blog, the OBR’s short-term figures on spending growth critically depend on the ability of households to absorb the negative shocks to their real income. Empirical evidence tends to show that household spending growth is less variable than that in income and that households try and smooth, if they can, their spending. Therefore, the marginal propensity of households to consume out of changes in their income is below 1 in the short-run. This is consistent with the idea that households are consumption-smoothers disliking excessively volatile spending patterns.

The actual figures for consumption and income growth in 2011 help to show that consumption-smoothing cannot be taken for granted. In 2011, the fall in consumption exactly matched that in income. An important impediment to consumption-smoothing in recent times has been the impact of the financial crisis on bank lending. Banks have become more cautious in their lending and so households have been less able to borrow to support their spending in the face of falling real incomes. Another impediment to consumption-smoothing is likely to be the continuing unease amongst households to borrow (assuming they can) or to draw too heavily on their savings. In uncertain times, households may feel the need for a larger buffer stock of wealth to act as a security blanket.

In short, the latest OBR figures suggest that the growth in consumption in the medium-term will remain relatively weak. Retailers are likely to ‘feel the pinch’ for some time to come.

Articles
OBR raises forecast for economic growth Financial Times, Chris Giles (19/03/12)
Threat of recession receding but economy still at risk, says OBR Guardian, Katie Allen (21/3/12)
Punch Tavern sees profits slump 19pc Telegraph, Natalie Thomas (12/4/12)
U.K. Consumer spending slows as fuel prices climb, Times says Bloomberg, Agnieszka Troszkiewicz (7/4/12) )
Uk retail sales warmed by sunny weather in March BBC News (11/4/12)
Budget 2012: George Osborne raises UK growth forecast BBC News (21/4/12)

Data
Quarterly National Accounts, time series dataset Q4 2011 Office for National Statistics (see consumption series ABJR and HAYO in Table C2; disposable income series NRJR in Table J2 and GDP series ABMI in Table A2).

Questions

  1. Compare the consumption forecasts produced by the Office for Budget Responsibility in March 2012 with those it produced in November 2011. To see the earlier forecasts go to Gloomy prospects for spending in 2012?
  2. What do you understand by a consumption function? What variables would you include in such a function?
  3. Using the figures in the table in the text above, calculate ‘rough’ estimates of the income elasticity of consumption for each year. Why are these estimates only ‘rough’ approximations of the income elasticity of consumer spending?
  4. Draw up a list of factors that are likely to affect the strength of consumer spending in 2012. Explain how similar or different these factors are likely to have been to those that may affect spending during periods of strong economic growth.
  5. Explain what you understand by the term consumption-smoothing. Explore how households can smooth their spending and the factors that are likely to both help and prevent them from doing so.
  6. What do you understand by the net worth of households? Try drawing up a list of factors that could affect the net worth of households and then analyse how they might affect consumer spending.
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‘A new and even stronger era for trade’

International trade brings various benefits to an economy. One is that it can stimulate economic growth – something the UK government would very much like to achieve in current circumstances.

As one of the components of aggregate demand, net exports is a key variable that can create jobs and growth in an economy, and it is this variable that is being directly targeted in a trade agreement between the UK and South Korea. Growth in developing countries is far outstripping that in the West and through this trade deal, the UK is hoping to benefit from some of this growth – to the tune of about £500m per year.

South Korea already trades a huge amount with the UK – we are its second largest European trade partner after Germany. The Free Trade Area that has been agreed will put British firms in a stronger position when negotiating contracts, especially in relation to sporting events, such as the Asian Games in 2014, the World Student Games in 2015 and the Pyeongchang Winter Olympics in 2018. Nick Clegg, who announced the agreement said:

‘The best of British design, innovation and services will have even greater opportunity to show their strength in South Korea. UK and Korean companies will be able to form alliances on multi-billion pound projects across the world.’

Some of the benefits of this agreement may be seen relatively soon, as the South Korea National Pension Service has announced plans to set up a base in London, which would create a much need injection of investment into the stagnant economy. This latest trade deal is very much a part of the Coalition’s strategy of creating stronger ties and trade links to the fast growing emerging markets. The size of these potential benefits and the speed with which they emerge can only be estimated, but if they do materialise they will undoubtedly have positive effects on economic growth. The following articles consider these ‘economic opportunities in the UK’.

Nick Clegg hails Korean trade deal as £2bn opportunity for Britain Telegraph, Anna White (25/3/12)
South Korea trade deal ‘may bring £500m to UK economy’ BBC News (26/3/12)
South Korea’s $320bn pension fund to set up London base Guardian (26/3/12)
S Korea pension fund to set up London office Financial Times, Elizabeth Rigby (25/3/12)
Nick Clegg boosts British business in South Korea The Economic Voice, Jeff Taylor (26/3/12)

Questions

  1. What are the benefits and costs of trade? To whom do they accrue?
  2. The articles talk about a free trade area. What are the characteristics of such an agreement?
  3. What other types of trade agreement are there? In each case, find examples of that type of agreement.
  4. Why is trade seen as an engine of growth? Think about aggregate demand and how this can explain a boost to national income.
  5. If the South Korea National Pension Service does create a base in London, explain how the multiplier effect might create additional benefits to the UK.
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The recent rise and fall of a Keynesian consensus

Here’s an excellent article (the first link below) for giving an overview of macroeconomic thinking and policy since the start of the financial crisis in 2007. It looks at how a Keynesian consensus emerged in 2008–9, culminating in policies of fiscal and monetary stimulus being adopted in most major economies.

It also looks at how this consensus broke down from 2010 with the subsequent problem of rising public-sector deficits and debt, and was replaced by a new, although less widespread, consensus of fiscal restraint.

The article is not just about economic theory and policy, but also about the process and politics of how consensus and ‘dissensus’ emerge. It looks at the spread of ideas as a process of ‘contagion’ and how dissent may reflect the view of different defined groups, such as political parties or schools of economic thought.

Consensus, Dissensus and Economic Ideas: The Rise and Fall of Keynesianism During the Economic Crisis, Henry Farrell (George Washington University) and John Quiggin (University of Queensland) (9/3/12)
Keynesianism in the Great Recession Out of the Crooked Timber, Henry Farrell (9/3/12)
Economics in the Crisis (see also) The Conscience of a Liberal, Paul Krugman (5/3/12)

Questions

  1. What were the features of the Keynesian consensus in 2008–9?
  2. To what extent can the consensus of that period be described as the result of ‘contagion’?
  3. Why did consensus break down in 2010?
  4. How do economic experts play a political role in economic crises?
  5. To what extent does a lack of consensus benefit politicians?
  6. Why may the appearance of a consensus be more important in driving policy than actual consensus?