Category: Economics 10e: Ch 20

To make a sensible comparison of one year’s national income generated from the production of goods and services with another we need to take inflation into account. Changes in inflation-adjusted GDP represent changes in the volume of production of a country’s goods and services: in other words, the real value of goods and services. We revisit the blog written back in April 2019, prior the pandemic, to show how changes in real GDP evidence what we may refer to as the twin characteristics of economic growth: positive long-term growth but with fluctuating short-term rates of growth.

Real and nominal GDP

The nominal or current-price estimate for UK Gross Domestic Product in 2020 is £2.156 trillion. It is the value of output produced within the country in 2020. This was a fall of 4.4 per cent on the £2.255 trillion recorded in 2019. These values make no adjustment for inflation and therefore reflect the prices of output that were prevailing at the time.

Chart 1 shows current-price estimates of GDP from 1950 when the value of GDP was estimated at £12.7 billion. The increase to £2.156 trillion in 2020 amounts to a proportionate increase of almost 170 times, a figure that rises to 211 times if we compare the 1950 value with the latest IMF estimate for 2025 of £2.689 trillion. However, if we want to make a more meaningful comparison of the country’s national income by looking at the longer-term increase in the volume of production, we need to adjust for inflation. (Click here to download a PowerPoint copy of the chart.)

Long-term growth in real GDP

If we measure GDP at constant prices, we eliminate the effect of inflation. To construct a constant-price series for GDP a process known as chain-linking is used. This involves taking consecutive pairs of years, e.g. 2020 and 2021, and estimating what GDP would be in the most recent year (in this case, 2021) if the previous year’s prices (i.e. 2020) had continued to prevail. By calculating the percentage change from the previous year’s GDP value we have an estimate of the volume change. If this is repeated for other pairs of years, we have a series of percentage changes that capture the volume changes from year-to-year. Finally, a reference year is chosen and the percentage changes are applied backwards and forwards from the nominal GDP value for the reference year – the volume changes forwards and backwards from this point.

In effect, a real GDP series creates a quantity measure in monetary terms. Chart 1 shows GDP at constant 2019 prices (real GDP) alongside GDP at current prices (nominal GDP). Consider first the real GDP numbers for 1950 and 2020. GDP in 1950 at 2019 prices was £410.1 billion. This is higher than the current-price value because prices in 2019 (the reference year) were higher than those in 1950. Meanwhile, GDP in 2020 when measured at 2019 prices was £2.037 trillion. This constant-price value is smaller than the corresponding current-price value because prices in 2019 where lower than those in 2020.

Between 1950 and 2020 real GDP increased 5.0 times. If we extend the period to 2025, again using the latest IMF estimates, the increase is 5.9 times. Because we have removed the effect of inflation, the real growth figure is much lower than the nominal growth figure. Crucially, what we are left with is an indicator of the long-term growth in the volume of the economy’s output and hence an increase in national income that is backed up by an increase in production. Whereas nominal growth rates are affected both by changes in volumes and prices, real growth rates reflect only changes in volumes.

The upward trajectory observed in constant-price GDP is therefore evidence of positive longer-term growth. This is one of the twin characteristics of growth.

Short-term fluctuations in the growth of real GDP

The second characteristic is fluctuations in the rate of growth from period to period. We can see this second characteristic more clearly by plotting the percentage change in real GDP from year to year.

Chart 2 shows the annual rate of growth in real GDP each year since 1950. From it, we see the inherent instability that is a key characteristic of the macroeconomic environment. This instability is, of course, mirrored in the output path of real GDP in Chart 1, but the annual rates of growth show the instability more clearly. We can readily see the impact on national output of the global financial crisis and the global health emergency.

In 2009, constant-price GDP in the UK fell by 4.25 per cent. Then, in 2020, constant-price GDP and, hence, the volume of national output fell by 9.7 per cent, as compared to a 4.4 per cent fall in current-price GDP that we identified earlier. These global, ‘once-in-a-generation’ shocks are stark examples of the instability that characterises economies and which generate the ‘ups and downs’ in an economy’s output path, known more simply as ‘the business cycle’. (Click here to download a PowerPoint copy of the chart.)

Determinants of long-and short-term growth

The twin characteristics of growth can be seen simultaneously by combining the output path captured by the levels of real GDP with the annual rates of growth. This is shown in Chart 3. The longer-term growth seen in the economy’s output path is generally argued to be driven by the quantity and quality of the economy’s resources, and their effectiveness when combined in production. In other words, it is the supply-side that determines the trajectory of the output path over the longer term. (Click here to download a PowerPoint copy of the chart.)

However, the fluctuations we observe in short-term growth rates tend to reflect impulses that affect the ability and or willingness of producers to supply (supply-side shocks) and purchasers to consume (demand-side shocks). These impulses are then propagated and their effects, therefore, transmitted through the economy.

Effects of the pandemic

The pandemic is unusual in that the health intervention measures employed by governments around the world resulted in simultaneous negative aggregate demand and aggregate supply shocks. Economists were particularly concerned that the magnitude of these impulses and their propagation had the potential to generate scarring effects and hence negative hysteresis effects. The concern was that these would affect the level of real GDP in the medium-to-longer term and, hence, the vertical position of the output path, as well as the longer-term rate of growth and, hence, the steepness of the output path.

The extent of these scarring effects continues to be debated. The ability of businesses and workers to adapt their practices, the extraordinary fiscal and monetary measures that were undertaken in many countries, and the roll-out of vaccines programmes, especially in advanced economies, have helped to mitigate some of these effects. For example, the latest IMF forecasts for output in the USA in 2024 are over 2 per cent higher than those made back in October 2019.

Scarring effects are, however, thought to be an ongoing issue in the UK. The IMF is now expecting output in the UK to be nearly 3 per cent lower than it originally forecast back in October 2019. Therefore, whilst UK output is set to recover, scarring effects on the UK economy will mean that the output path traced out by real GDP will remain, at least in the medium term, vertically lower than was expected before the pandemic.

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Questions

  1. What do you understand by the term ‘macroeconomic environment’? What data could be used to describe the macroeconomic environment?
  2. When a country experiences positive rates of inflation, which is higher: nominal economic growth or real economic growth?
  3. Does an increase in nominal GDP mean a country’s production has increased? Explain your answer.
  4. Does a decrease in nominal GDP mean a country’s production has decreased? Explain your answer.
  5. Why does a change in the growth of real GDP allow us to focus on what has happened to the volume of production?
  6. What does the concept of the ‘business cycle’ have to do with real rates of economic growth?
  7. When would falls in real GDP be classified as a recession?
  8. Distinguish between the concepts of ‘short-term growth rates’ and ‘longer-term growth’.
  9. What do you understand by the term hysteresis? By what means can hysteresis effects be generated?
  10. Discuss the proposition that the pandemic could have a positive effect on longer-term growth rates because of the ways that people and business have had to adapt.

The COVID-19 pandemic had a stark effect on countries’ public finances. Governments had to make difficult fiscal choices around spending and taxation to safeguard public health, and the protection of jobs and incomes both in the present and in the future. The fiscal choices were to have historically large effects on the size of public spending and on the size of public borrowing. Here we briefly summarise the magnitude of these effects on public spending, receipts and borrowing in the UK.

The public sector comprises both national government and local or regional government. In financial year 2019/20 public spending in the UK was £886 billion. This would rise to £1.045 trillion in 2020/21. To understand better the magnitude of these figures we can express them as a share of national income (Gross Domestic Product). In 2019/20 public spending was 39.8 per cent of national income. This rose to 52.1 per cent in 2020/21. Meanwhile, public-sector receipts, largely taxation, fell from £829.1 billion in 2019/20 to £796.5 billion in 2020/21, though, because of the fall in national income, the share of receipts in national income rose very slightly from 37.3 to 37.9 per cent of national income.

The chart shows both public spending and public receipts as a share of national income since 1900. (Click here for a PowerPoint of the chart.) What this chart shows is the extraordinary impact of the two World Wars on the relative size of public spending. We can also see an uptick in public spending following the global financial crisis and, of course, the COVID-19 pandemic. The chart also shows that spending is typically larger than receipts meaning that the public sector typically runs a budget deficit. .
If we focus on public spending as a share of national income and its level following the two world wars, we can see that it did not fall back to pre-war levels. This is what Peacock and Wiseman (1961) famously referred to as a displacement effect. They attributed this to, among other things, an increase in the public’s tolerance to pay higher taxation because of the higher taxes levied during the war as well as to a desire for greater public intervention. The latter arose from an inspection effect. This can be thought of as a public consciousness effect, with the war helping to shine a light on a range of economic and social issues, such as health, housing and social security. These two effects, it is argued, reinforced each other, allowing the burden of taxation to rise and, hence, public spending to increase relative to national income.

If we forward to the global financial crisis, we can again see public spending rise as a share of national income. However, this time the ratio did not remain above pre-crisis levels. Rather, the UK government was fearful of unsustainable borrowing levels and the crowding out of private-sector activity by the public sector, with higher interest rates making public debt an attractive proposition for investors. It thus sought to reduce the public-sector deficit by engaging in what became known as ‘austerity’ measures.

If we move forward further to the COVID-19 pandemic, we see an even more significant spike in public spending as a share of national income. It is of course rather early to make predictions about whether the pandemic will have enduring effects on public spending and taxation. Nonetheless the pandemic, in a similar way to the two world wars, has sparked public debates on many economic and social issues. Whilst debates around the funding of health and social care are longstanding, it could be argued that the pandemic has provided the government with the opportunity to introduce the 1.25 percentage point levy from April 2022 on the earned incomes of workers (both employees and the self-employed) and on employers. (See John’s blog Fair care? for a fuller discussion on the tax changes to pay for increased health and social care expenditure).

The extent to which there may be a pandemic displacement effect will depend on the fiscal choices made in the months and years ahead. The key question is how powerful will be the effect of social issues like income and wealth inequality, regional and inter-generational disparities, discrimination, poor infrastructure and educational opportunities in shaping these fiscal choices? Will these considerations carry more weight than the push to consolidate the public finances and tighten the public purse? These fiscal choices will determine the extent of any displacement effect in public spending and taxation.

Reference

Alan Peacock and Jack Wiseman, The Growth in Public Expenditure in the United Kingdom, Princeton University Press (1961).

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Questions

  1. What do you understand by the term ‘public finances’?
  2. Why might you wish to express the size of public spending relative to national income rather than simply as an absolute amount?
  3. Undertake research to identify key pieces of social policy in the UK that were enacted at or around the times of the two World Wars.
  4. What do you understand by the terms ‘tolerable tax burden’ and ‘inspection effect’?
  5. Identify those social issues that you think have come into the spotlight as a result of the pandemic. Undertake research on any one of these and write a briefing note exploring the issue and the possible policy choices available to government.
  6. What is the concept of crowding out? How might it affect fiscal choices?
  7. How would you explain the distinction between public-sector borrowing and public-sector debt? Why could the former fall and the latter rise at the same time?

The OECD has recently published its six-monthly Economic Outlook. This assesses the global economic situation and the prospects for the 38 members of the OECD.

It forecasts that the UK economy will bounce back strongly from the deep recession of 2020, when the economy contracted by 9.8 per cent. This contraction was deeper than in most countries, with the USA contracting by 3.5 per cent, Germany by 5.1 per cent, France by 8.2 per cent, Japan by 4.7 per cent and the OECD as a whole by 4.8 per cent. But, with the success of the vaccine roll-out, UK growth in 2021 is forecast by the OECD to be 7.2 per cent, which is higher than in most other countries. The USA is forecast to grow by 6.8 per cent, Germany by 3.3 per cent, France by 5.8 per cent, Japan by 2.6 per cent and the OECD as a whole by 5.3 per cent. Table 1 in the Statistical Annex gives the figures.

This good news for the UK, however, is tempered by some worrying features.

The OECD forecasts that potential economic growth will be negative in 2021, with capacity declining by 0.4 per cent. Only two other OECD countries, Italy and Greece, are forecast to have negative potential economic growth (see Table 24 in the Statistical Annex). A rapid increase in aggregate demand, accompanied by a decline in aggregate supply, could result in inflationary pressures, even if initially there is considerable slack in some parts of the economy.

Part of the reason for the supply constraints are the additional barriers to trade with the EU resulting from Brexit. The extra paperwork for exporters has added to export costs, and rules-of-origin regulations add tariffs to many exports to the EU (see the blog A free-trade deal? Not really). Another supply constraint linked to Brexit is the shortage of labour in certain sectors, such as hospitality, construction and transport. With many EU citizens having left the UK and not being replaced by equivalent numbers of new immigrants, the problem is likely to persist.

The scarring effects of the pandemic present another problem. There has been a decline in investment. Even if this is only temporary, it will have a long-term impact on capacity, unless there is a compensating rise in investment in the future. Many businesses have closed and will not re-open, including many High Street stores. Moves to working from home, even if partially reversed as the economy unlocks, will have effects on the public transport industry. Also, people may have found new patterns of consumption, such as making more things for themselves rather than buying them, which could affect many industries. It is too early to predict the extent of these scarring effects and how permanent they will be, but they could have a dampening effect on certain sectors.

Inflation

So will inflation take off, or will it remain subdued? At first sight it would seem that inflation is set to rise significantly. Annual CPI inflation rose from 0.7 per cent in March 2021 to 1.5 per cent in April, with the CPI rising by 0.6 per cent in April alone. What is more, the housing market has seen a large rise in demand, with annual house price inflation reaching 10.2 per cent in March.

But these rises have been driven by some one-off events. As the economy began unlocking, so spending rose dramatically. While this may continue for a few months, it may not persist, as an initial rise in household spending may reflect pent-up demand and as the furlough scheme comes to an end in September.

As far as as the housing market is concerned, the rise in demand has been fuelled by the stamp duty ‘holiday’ which exempts residential property purchase from Stamp Duty Land Tax for properties under £500 000 in England and Northern Ireland and £250 000 in Scotland and Wales (rather than the original £125 000 in England and Northern Ireland, £145 000 in Scotland and £180 000 in Wales). In England and Northern Ireland, this limit is due to reduce to £250 000 on 30 June and back to £125 000 on 30 September. In Scotland the holiday ended on 31 March and in Wales is due to end on 30 June. As these deadlines are passed, this should see a significant cooling of demand.

Finally, although the gap between potential and actual output is narrowing, there is still a gap. According to the OECD (Table 12) the output gap in 2021 is forecast to be −4.6 per cent. Although it was −11.4 per cent in 2020, a gap of −4.6 per cent still represents a significant degree of slack in the economy.

At the current point in time, therefore, the Bank of England does not expect to have to raise interest rates in the immediate future. But it stands ready to do so if inflation does show signs of taking off.

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Questions

  1. What determines the rate of (a) actual economic growth; (b) potential economic growth?
  2. What is meant by an output gap? What would be the implications of a positive output gap?
  3. Why are scarring effects of the pandemic likely to be greater in the UK than in most other countries?
  4. If people believed that inflation was likely to continue rising, how would this affect their behaviour and how would it affect the economy?
  5. What are the arguments for and against having a stamp duty holiday when the economy is in recession?

Rishi Sunak delivered his 2021 UK Budget on 3 March. It illustrates the delicate balancing act that governments in many countries face as the effects of the coronavirus pandemic persist and public-sector debt soars. He announced that he would continue supporting the economy through various forms of government expenditure and tax relief, but also announced tax rises over the medium term to begin addressing the massively increased public-sector debt.

Key measures of support for people and businesses include:

  • An extension of the furlough scheme until the end of September, with employees continuing to be paid 80% of their wages for hours they cannot work, but with employers having to contribute 10% in July and 20% in August and September.
  • Support for the self-employed also extended until September, with the scheme being widened to make 600 000 more self-employed people eligible.
  • The temporary £20 increase to Universal Credit, introduced in April last year and due to end on 31 March this year, to be extended to the end of September.
  • Stamp duty holiday on house purchases in England and Northern Ireland, under which there is no tax liability on sales of less than £500 000, extended from the end of March to the end of June.
  • An additional £1.65bn to support the UK’s vaccination rollout.
  • VAT rate for hospitality firms to be maintained at the reduced 5% rate until the end of September and then raised to 12.5% (rather than 20%) for a further six months.
  • A range of grants for the arts, sport, shops , other businesses and apprenticeships.
  • Business rates holiday for hospitality firms in England extended from the end of March to the end of June and then with a discount of 66% until April 2022.
  • 130% of investment costs can be offset against tax – a new tax ‘super-deduction’.
  • No tax rises on alcohol, tobacco or fuel.
  • New UK Infrastructure Bank to be set up in Leeds with £12bn in capital to support £40bn worth of public and private projects.
  • Increased grants for devolved nations and grants for 45 English towns.

It has surprised many commentators that there was no announcement of greater investment in the NHS or more money for social care beyond the £3bn for the NHS and £1bn for social care announced in the November Spending Review. The NHS England budget will fall from £148bn in 2020/21 to £139bn in 2021/22.

Effects on borrowing and GDP


The net effect of these measures for the two financial years 2020 to 2022 is forecast by the Treasury to be an additional £37.5bn of government expenditure and a £27.3bn reduction in tax revenue (see Table 2.1 in Budget 2021). This takes the total support since the start of the pandemic to £352bn across the two years.

According to the OBR, this will result in public-sector borrowing being 16.9% of GDP in 2020/21 (the highest since the Second World War) and 10.3% of GDP in 2021/22. Public-sector debt will be 107.4% of GDP in 2021/22, rising to 109.7% in 2023/24 and then falling to 103.8% in 2025/26.

Faced with this big increase in borrowing, the Chancellor also announced some measures to raise tax revenue beginning in two years’ time when, hopefully, the economy will have grown. Indeed, the OBR forecasts that GDP will grow by 4.0% in 2021 and 7.3% in 2022, with the growth rate then settling at around 1.7% from 2023 onwards. He announced that:

  • Corporation tax on company profits over £250 000 will rise from 19% to 25% in April 2023. Rates for profits under £50 000 will remain at the current rate of 19%, with the rate rising in stages as profits rise above £50 000.
  • Personal income tax thresholds will be frozen from 2022/23 to 2025/26 at £12 570 for the basic 20% marginal rate and at £50 270 for the 40% marginal rate. This will increase the average tax rate as people’s nominal incomes rise.

The policy of a fiscal boost now and a fiscal tightening later might pose political difficulties for the government as this does not fit with the electoral cycle. Normally, politicians like to pursue tighter policies in the early years of the government only to loosen policy with various giveaways as the next election approaches. With Rishi Sunak’s policies, the opposite is the case, with fiscal policy being tightened as the 2024 election approaches.

Another issue is the high degree of uncertainty in the forecasts on which he is basing his policies. If there is another wave of the coronavirus with a new strain resistant to the vaccines or if the scarring effects of the lockdowns are greater, then growth could stall. Or if inflation begins to rise and the Bank of England feels it must raise interest rates, then this would suppress growth. With lower growth, the public-sector deficit would be higher and the government would be faced with the dilemma of whether it should raise taxes, cut government expenditure or accept higher borrowing.

What is more, there are likely to be huge pressures on the government to increase public spending, not cut it by £4bn per year in the medium term as he plans. As Paul Johnson of the IFS states:

In reality, there will be pressures from all sorts of directions. The NHS is perhaps the most obvious. Further top-ups seem near-inevitable. Catching up on lost learning in schools, dealing with the backlog in our courts system, supporting public transport providers, and fixing our system for social care funding would all require additional spending. The Chancellor’s medium-term spending plans simply look implausibly low.

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Questions

  1. Assess the wisdom of the timing of the changes in tax and government expenditure announced in the Budget.
  2. Universal credit was increased by £20 per week in April 2020 and is now due to fall back to its previous level in October 2021. Have the needs of people on Universal Credit increased during the pandemic and, if so, are they likely to return to their previous level in October?
  3. In the past, the government argued that reductions in the rate of corporation tax would increase tax revenue. The Chancellor now argues that increasing it from 19% to 25% will increase tax revenue. Examine the justification for this increase and the significance of relative profit tax rates between countries.
  4. Investigate the effects on the public finances of the pandemic and government fiscal policy in two other countries. How do the effects compare with those in the UK?
  5. The Joseph Rowntree Foundation looks at poverty in the UK and policies to tackle it. It set five tests for the Budget. Examine its Budget Analysis and consider whether these tests have been met.

On 25 November, the UK government published its Spending Review 2020. This gives details of estimated government expenditure for the current financial year, 2020/21, and plans for government expenditure and the likely totals for 2021/22.

The focus of the Review is specifically on the effects of and responses to the coronavirus pandemic. It does not consider the effects of Brexit, with or without a trade deal, or plans for taxation. The Review is based on forecasts by the Office for Budget Responsibility (OBR). Because of the high degree of uncertainty over the spread of the disease and the timing and efficacy of vaccines, the OBR gives three forecast values for most variables – pessimistic, central and optimistic.

According to the central forecast, real GDP is set to decline by 11.3% in 2020, the largest one-year fall since the Great Frost of 1709. The economy is then set to ‘bounce back’ (somewhat), with GDP rising by 5.2% in 2021.

Unemployment will rise from 3.9% in 2019 to a peak of 7.5% in mid-2021, after the furlough scheme and other support for employers is withdrawn.

This blog focuses at the impact on government borrowing and debt and the implications for the future – both the funding of the debt and ways of reducing it.

Soaring government deficits and debt


Government expenditure during the pandemic has risen sharply through measures such as the furlough scheme, the Self-Employment Income Support Scheme and various business loans. This, combined with falling tax revenue, as incomes and consumer expenditure have declined, has led to a rise in public-sector net borrowing (PSNB) from 2.5% of GDP in 2019/20 to a central forecast of 19% for 2020/21 – the largest since World War II. By 2025/26 it is still forecast to be 3.9% of GDP. The figure has also been pushed up by a fall in nominal GDP for 2020/21 (the denominator) by nearly 7%. (Click here for a PowerPoint of the above chart.)

The high levels of PSNB are pushing up public-sector net debt (PSNB). This is forecast to rise from 85.5% of GDP in 2019/20 to 105.2% in 2020/21, peaking at 109.4% in 2023/24.

The exceptionally high deficit and debt levels will mean that the government misses by a very large margin its three borrowing and debt targets set out in the latest (Autumn 2016) ‘Charter for Budget Responsibility‘. These are:

  • to reduce cyclically-adjusted public-sector net borrowing to below 2% of GDP by 2020/21;
  • for public-sector net debt as a percentage of GDP to be falling in 2020/21;
  • for overall borrowing to be zero or in surplus by 2025/26.

But, as the Chancellor said in presenting the Review:

Our health emergency is not yet over. And our economic emergency has only just begun. So our immediate priority is to protect people’s lives and livelihoods.

Putting the public finances on a sustainable footing

Running a large budget deficit in an emergency is an essential policy for dealing with the massive decline in aggregate demand and for supporting those who have, or otherwise would have, lost their jobs. But what of the longer-term implications? What are the options for dealing with the high levels of debt?

1. Raising taxes. This tends to be the preferred approach of those on the left, who want to protect or improve public services. For them, the use of higher progressive taxes, such as income tax, or corporation tax or capital gains tax, are a means of funding such services and of providing support for those on lower incomes. There has been much discussion of the possibility of finding a way of taxing large tech companies, which are able to avoid taxes by declaring very low profits by diverting them to tax havens.

2. Cutting government expenditure. This is the traditional preference of those on the right, who prefer to cut the overall size of the state and thus allow for lower taxes. However, this is difficult to do without cutting vital services. Indeed, there is pressure to have higher government expenditure over the longer term to finance infrastructure investment – something supported by the Conservative government.

A downside of either of the above is that they squeeze aggregate demand and hence may slow the recovery. There was much discussion after the financial crisis over whether ‘austerity policies’ hindered the recovery and whether they created negative supply-side effects by dampening investment.

3. Accepting higher levels of debt into the longer term. This is a possible response as long as interest rates remain at record low levels. With depressed demand, loose monetary policy may be sustainable over a number of years. Quantitative easing depresses bond yields and makes it cheaper for governments to finance borrowing. Servicing high levels of debt may be quite affordable.

The problem is if inflation begins to rise. Even with lower aggregate demand, if aggregate supply has fallen faster because of bankruptcies and lack of investment, there may be upward pressure on prices. The Bank of England may have to raise interest rates, making it more expensive for the government to service its debts.

Another problem with not reducing the debt is that if another emergency occurs in the future, there will be less scope for further borrowing to support the economy.

4. Higher growth ‘deals’ with the deficit and reduces debt. In this scenario, austerity would be unnecessary. This is the ‘golden’ scenario – for the country to grow its way out of the problem. Higher output and incomes leads to higher tax revenues, and lower unemployment leads to lower expenditure on unemployment benefits. The crucial question is the relationship between aggregate demand and supply. For growth to be sustainable and shrink the debt/GDP ratio, aggregate demand must expand steadily in line with the growth in aggregate supply. The faster aggregate supply can grow, the faster can aggregate demand. In other words, the faster the growth in potential GDP, the faster can be the sustainable rate of growth of actual GDP and the faster can the debt/GDP ratio shrink.

One of the key issues is the degree of economic ‘scarring’ from the pandemic and the associated restrictions on economic activity. The bigger the decline in potential output from the closure of firms and the greater the deskilling of workers who have been laid off, the harder it will be for the economy to recover and the longer high deficits are likely to persist.

Another issue is the lack of labour productivity growth in the UK in recent years. If labour productivity does not increase, this will severely restrict the growth in potential output. Focusing on training and examining incentives, work practices and pay structures are necessary if productivity is to rise significantly. So too is finding ways to encourage firms to increase investment in new technologies.

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Questions

  1. What is the significance of the relationship between the rate of economic growth and the rate of interest for financing public-sector debt over the longer term?
  2. What can the government do to encourage investment in the economy?
  3. Using OBR data, find out what has happened to the output gap over the past few years and what is forecast to happen to it over the next five years. Explain the significance of the figures.
  4. Distinguish between demand-side and supply-side policies. How would you characterise the policies to tackle public-sector net debt in terms of this distinction? Do the policies have a mixture of demand- and supply-side effects?
  5. Choose two other developed countries. Examine how their their public finances have been affected by the coronavirus pandemic and the policies they are adopting to tackle the economic effects of the pandemic.