Category: Economics 10e: Ch 16

The global economic impact of the coronavirus outbreak is uncertain but potentially very large. There has already been a massive effect on China, with large parts of the Chinese economy shut down. As the disease spreads to other countries, they too will experience supply shocks as schools and workplaces close down and travel restrictions are imposed. This has already happened in South Korea, Japan and Italy. The size of these effects is still unknown and will depend on the effectiveness of the containment measures that countries are putting in place and on the behaviour of people in self isolating if they have any symptoms or even possible exposure.

The OECD in its March 2020 interim Economic Assessment: Coronavirus: The world economy at risk estimates that global economic growth will be around half a percentage point lower than previously forecast – down from 2.9% to 2.4%. But this is based on the assumption that ‘the epidemic peaks in China in the first quarter of 2020 and outbreaks in other countries prove mild and contained.’ If the disease develops into a pandemic, as many health officials are predicting, the global economic effect could be much larger. In such cases, the OECD predicts a halving of global economic growth to 1.5%. But even this may be overoptimistic, with growing talk of a global recession.

Governments and central banks around the world are already planning measures to boost aggregate demand. The Federal Reserve, as an emergency measure on 3 March, reduced the Federal Funds rate by half a percentage point from the range of 1.5–1.75% to 1.0–1.25%. This was the first emergency rate cut since 2008.

Economic uncertainty

With considerable uncertainty about the spread of the disease and how effective containment measures will be, stock markets have fallen dramatically. The FTSE 100 fell by nearly 14% in the second half of February, before recovering slightly at the beginning of March. It then fell by a further 7.7% on 9 March – the biggest one-day fall since the 2008 financial crisis. This was specifically in response to a plunge in oil prices as Russia and Saudi Arabia engaged in a price war. But it also reflected growing pessimism about the economic impact of the coronavirus as the global spread of the epidemic accelerated and countries were contemplating more draconian lock-down measures.

Firms have been drawing up contingency plans to respond to panic buying of essential items and falling demand for other goods. Supply-chain managers are working out how to respond to these changes and to disruptions to supplies from China and other affected countries.

Firms are also having to plan for disruptions to labour supply. Large numbers of employees may fall sick or be advised/required to stay at home. Or they may have to stay at home to look after children whose schools are closed. For some firms, having their staff working from home will be easy; for others it will be impossible.

Some industries will be particularly badly hit, such as airlines, cruise lines and travel companies. Budget airlines have cancelled several flights and travel companies are beginning to offer substantial discounts. Manufacturing firms which are dependent on supplies from affected countries have also been badly hit. This is reflected in their share prices, which have seen large falls.

Longer-term effects

Uncertainty could have longer-term impacts on aggregate supply if firms decide to put investment on hold. This would also impact on the capital goods industries which supply machinery and equipment to investing firms. For the UK, already having suffered from Brexit uncertainty, this further uncertainty could prove very damaging for economic growth.

While aggregate supply is likely to fall, or at least to grow less quickly, what will happen to the balance of aggregate demand and supply is less clear. A temporary rise in demand, as people stock up, could see a surge in prices, unless supermarkets and other firms are keen to demonstrate that they are not profiting from the disease. In the longer term, if aggregate demand continues to grow at past rates, it will probably outstrip the growth in aggregate supply and result in rising inflation. If, however, demand is subdued, as uncertainty about their own economic situation leads people to cut back on spending, inflation and even the price level may fall.

How quickly the global economy will ‘bounce back’ depends on how long the outbreak lasts and whether it becomes a serious pandemic and on how much investment has been affected. At the current time, it is impossible to predict with any accuracy the timing and scale of any such bounce back.

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Questions

  1. Using a supply and demand diagram, illustrate the fall in stock market prices caused by concerns over the effects of the coronavirus.
  2. Using either (i) an aggregate demand and supply diagram or (ii) a DAD/DAS diagram, illustrate how a fall in aggregate supply as a result of the economic effects of the coronavirus would lead to (a) a fall in real income and (i) a fall in the price level or (ii) a fall in inflation; (b) a fall in real income and (i) a rise in the price level or (ii) a rise in inflation.
  3. What would be the likely effects of central banks (a) cutting interest rates; (b) engaging in further quantitative easing?
  4. What would be the likely effects of governments running a larger budget deficit as a means of boosting the economy?
  5. Distinguish between stabilising and destabilising speculation. How would you characterise the speculation that has taken place on stock markets in response to the coronavirus?
  6. What are the implications of people being paid on zero-hour contracts of the government requiring workplaces to close?
  7. What long-term changes to working practices and government policy could result from short-term adjustments to the epidemic?
  8. Is the long-term macroeconomic impact of the coronavirus likely to be zero, as economies bounce back? Explain.

With many countries experiencing low growth some 12 years after the financial crisis and with new worries about the effects of the coronavirus on output in China and other countries, some are turning to a Keynesian fiscal stimulus (see Case Study 16.6 on the student website). This may be in the form of tax cuts, or increased government expenditure or a combination of the two. The stimulus would be financed by increased government borrowing (or a reduced surplus).

The hope is that there will also be a longer-term supply-side effect which will boost potential national income. This could be through tax reductions creating incentives to invest or work more efficiently; or it could be through increased capacity from infrastructure spending, whether on transport, energy, telecommunications, health or education.

In the UK, the former Chancellor, Sajid Javid, had adopted a fiscal rule similar to the Golden Rule adopted by the Labour government from 1997 to 2008. This stated that, over the course of the business cycle, the government should borrow only to invest and not to fund current expenditure. Javid’s rule was that the government would balance its current budget by the middle of this Parliament (i.e. in 2 to 3 years) but that it could borrow to invest, provided that this did not exceed 3% of GDP. Previously this limit had been set at 2% of GDP by the former Chancellor, Philip Hammond. Using his new rule, it was expected that Sajid Javid would increase infrastructure spending by some £20 billion per year. This would still be well below the extra promised by the Labour Party if they had won the election and below what many believe Boris Johnson Would like.

Sajid Javid resigned at the time of the recent Cabinet reshuffle, citing the reason that he would have been required to sack all his advisors and use the advisors from the Prime Minister’s office. His successor, the former Chief Secretary to the Treasury, Rishi Sunak, is expected to adopt a looser fiscal rule in his Budget on March 11. This would result in bigger infrastructure spending and possibly some significant tax cuts, such as a large increase in the threshold for the 40% income tax rate.

A Keynesian stimulus would almost certainly increase the short-term economic growth rate as inflation is low. However, unemployment is also low, meaning that there is little slack in the labour market, and also the output gap is estimated to be positive (albeit only around 0.2%), meaning that national income is already slightly above the potential level.

Whether a fiscal stimulus can increase long-term growth depends on whether it can increase capacity. The government hopes that infrastructure expenditure will do just that. However, there is a long time lag between committing the expenditure and the extra capacity coming on stream. For example, planning for HS2 began in 2009. Phase 1 from London to Birmingham is currently expected to be operation not until 2033 and Phase 2, to Leeds and Manchester, not until 2040, assuming no further delays.

Crossrail (the new Elizabeth line in London) has been delayed several times. Approved in 2007, with construction beginning in 2009, it was originally scheduled to open in December 2018. It is now expected to be towards the end of 2021 before it does finally open. Its cost has increased from £14.8 billion to £18.25 billion.

Of course, some infrastructure projects are much quicker, such as opening new bus routes, but most do take several years.

The first five articles look at UK policy. The rest look at Keynesian fiscal policies in other countries, including the EU, Russia, Malaysia, Singapore and the USA. Governments seem to be looking for a short-term boost to aggregate demand that will increase short-term GDP, but also have longer-term supply-side effects that will increase the growth in potential GDP.

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Questions

  1. Illustrate the effect of an expansionary fiscal policy with a Keynesian Cross (income and expenditure) diagram or an injections and withdrawals diagram.
  2. What is meant by the term ‘output gap’? What are the implications of a positive output gap for expansionary Keynesian policy?
  3. Assess the benefits of having a fiscal rule that requires governments to balance the current budget but allows borrowing to invest.
  4. Would there be a problem following such a rule if there is currently quite a large positive output gap?
  5. To what extent are the policies being proposed in Russia, the EU, Malaysia and Singapore short-term demand management policies or long-term supply-side policies?

Elections are times of peak deception. Political parties have several ways in which they can use data to persuade people to vote for them. At one extreme, they can simply make up ‘facts’ – in other words, they can lie. There have been various examples of such lies in the run-up to the UK general election of 12 December 2019. The linked article below gives some examples. But data can be used in other deceptive ways, short of downright lies.

Politicians can use data in two ways. First, statistics can be used to describe, explain and interpret the past. Second, they can be used as the basis of forecasts of the future effects of policies.

In terms of past data, one of the biggest means of deception is the selective use of data. If you are the party currently in power, you highlight the good news and ignore the bad. You do the reverse if you are currently in opposition. The data may be correct, but selective use of data can give a totally false impression of events.

In terms of forecast data, you highlight those forecasts, or elements of them, that are favourable to you and ignore those that are not.

Politicians rely on people’s willingness to look selectively at data. People want to see ‘evidence’ that reinforces their political views and prejudices. News media know this and happily do the same as politicians, selectively using data favourable to their political leanings. And it’s not just newspapers that do this. There are many online news sites that feed their readers with data supportive of their position. And there are many social media platforms, where people can communicate with people in their political ‘bubble’.

Genuine fact-checking sites can help, as can independent forecasters, such as the Institute for Fiscal Studies. But too many voters would rather only look at evidence, genuine or not, that supports their political point of view.

This can make life hard for economists who seek to explain the world with an open mind, based on a non-biased use of evidence – and hard for economic forecasters, who want to use full and accurate data in their models and to make realistic assumptions, emphasising that their forecasts are only the most likely outcome, not a certainty. As the article states:

Economic forecasts are flawed and their limitations should be acknowledged. But they should not be blindly dismissed as fake facts. And as far as political debate and discourse is concerned, in the long run, the truth may will out.

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Questions

  1. Give some specific examples of ways in which politicians misuse data.
  2. Give some specific examples of ways in which politicians misuse the analysis of economists.
  3. Distinguish between positive and normative statements? Should economists make policy recommendations? If so, in what context?
  4. Why are economic forecasts flawed, but why should they not be dismissed as ‘fake facts’?
  5. Examine the manifestos of two political parties and provide a critique of their economic analysis.

Economists are often criticised for making inaccurate forecasts and for making false assumptions. Their analysis is frequently dismissed by politicians when it contradicts their own views.

But is this fair? Have economists responded to the realities of the global economy and to the behaviour of people, firms, institutions and government as they respond to economic circumstances? The answer is a qualified yes.

Behavioural economics is increasingly challenging the simple assumption that people are ‘rational’, in the sense that they maximise their self interest by weighing up the marginal costs and benefits of alternatives open to them. And macroeconomic models are evolving to take account of a range of drivers of global growth and the business cycle.

The linked article and podcast below look at the views of 2019 Nobel Prize-winning economist Esther Duflo. She has challenged some of the traditional assumptions of economics about the nature of rationality and what motivates people. But her work is still very much in the tradition of economists. She examines evidence and sees how people respond to incentives and then derives policy implications from the analysis.

Take the case of the mobility of labour. She examines why people who lose their jobs may not always move to a new one if it’s in a different town. Partly this is for financial reasons – moving is costly and housing may be more expensive where the new job is located. Partly, however, it is for reasons of identity. Many people are attached to where they currently live. They may be reluctant to leave family and friends and familiar surroundings and hope that a new job will turn up – even if it means a cut in wages. This is not irrational; it just means that people are driven by more than simply wages.

Duflo is doing what economists typically do – examining behaviour in the light of evidence. In her case, she is revisiting the concept of rationality to take account of evidence on what motivates people and the way they behave.

In the light of workers’ motivation, she considers the implications for the gains from trade. Is free trade policy necessarily desirable if people lose their jobs because of cheap imports from China and other developing countries where labour costs are low?

The answer is not a clear yes or no, as import-competing industries are only part of the story. If protectionist policies are pursued, other countries may retaliate with protectionist policies themselves. In such cases, people working in the export sector may lose their jobs.

She also looks at how people may respond to a rise or cut in tax rates. Again the answer is not clear cut and an examination of empirical evidence is necessary to devise appropriate policy. Not only is there an income and substitution effect from tax changes, but people are motivated to work by factors other than take-home pay. Likewise, firms are encouraged to invest by factors other than the simple post-tax profitability of investment.

Podcast

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Questions

  1. In traditional ‘neoclassical’ economics, what is meant by ‘rationality’ in terms of (a) consumer behaviour; (b) producer behaviour?
  2. How might the concept of rationality be expanded to take into account a whole range of factors other than the direct costs and benefits of a decision?
  3. What is meant by bounded rationality?
  4. What would be the effect on workers’ willingness to work more or fewer hours as a result of a cut in the marginal income tax rate if (a) the income effect was greater than the substitution effect; (b) the substitution effect was greater than the income effect? Would your answers to (a) and (b) be the opposite in the case of a rise in the marginal income tax rate?
  5. Give some arguments that you consider to be legitimate for imposing controls on imports in (a) the short run; (b) the long run. How might you counter these arguments from a free-trade perspective?

When UK unemployment was 7.7% in July 2013, Mark Carney, the newly arrived governor of the Bank of England, said that the Bank would probably have to rise interest rates when the unemployment rate dropped below 7%. Below that rate, it was expected that inflation would rise. In other words, 7% was the NAIRU – the non-accelerating rate of inflation. The most recent figure for the unemployment rate is 4.8% and yet the Bank of England has not raised interest rates. In fact, in response to the Brexit vote, it cut Bank Rate from 0.5% to 0.25% in August last year. (Click here for a PowerPoint of the chart below.)

The NAIRU is a similar, although not identical, concept to the natural rate of unemployment. The natural rate is the equilibrium rate consistent with an overall long-term balance of aggregate labour demand and supply: i.e. the rate after short-term cyclical movements in unemployment have been discounted. It is thus a long-term concept.

The NAIRU, although similar, focuses on the relationship between inflation and unemployment. With inflation caused solely by demand-side factors, the natural rate and the NAIRU will be similar if not identical. However, if cost-push factors change – say there is a poor harvest, which pushes up food prices and inflation (temporarily), or a substantial depreciation of the exchange rate caused by political factors (such as Brexit) – the NAIRU would increase, at least in the short term, as a higher rate of unemployment would be necessary to stop inflation rising. In the long term, although being defined differently, the NAIRU and the natural rate will be the same.

In practice, because the Bank of England is targeting inflation at a 24-month time horizon, the NAIRU for the UK at that point could also be seen as the natural rate.

So with the Bank of England not raising interest rates despite the considerable fall in the unemployment rate, does this imply a fall in the natural rate of unemployment? The answer is yes. The reason has to do with changes in the structure of the labour market.

The proportion of young people and women with children returning to the labour market has fallen. Such people have a higher-than-average rate of unemployment since they typically spend a period of time searching for a job.

Tax and benefit reforms over the years have increased the incentive for the unemployed to take work.

Perhaps the biggest factor is a greater flexibility in the labour market. As union power has waned and as people are increasingly working on flexible contracts, including zero-hour contracts, so this has moderated wage increases. At the same time, many firms are facing increased competition both from abroad and domestically via the Internet. This has put downward pressure on prices and hence on the wages firms are willing to pay.

The effect has been a fall in the NAIRU and probably the natural rate. Frictions in the labour market have reduced and people losing their jobs because of changes in industrial structure find it easier to get jobs in low-skilled service industries, where employers’ risks of taking on such workers have fallen because of the loss of rights for such workers.

So what is the natural rate of unemployment today? It is certainly much lower than 7%; the consensus is that it is probably below 5%. As Kristin Forbes, External MPC Member of the Bank of England stated in a recent speech:

[Unemployment] is forecast to increase gradually from its current 4.8% to a high of 5.0% in the second half of 2017, before falling back to its current rate by the end of 2019. To put this in context, 5.0% was previously believed to be around the UK’s natural rate of unemployment – the rate below which unemployment could not fall without wages picking up to levels inconsistent with sustaining inflation around the 2% target. Unemployment at 5.0% is also below the average unemployment rate for the UK over the pre-crisis period from 1997 to 2007 (when it was 5.5%).

She went on to discuss just what the figure is for the natural, or ‘equilibrium’, rate of unemployment (U*). One problem here is that there is considerable uncertainty over the figure in the current forecast made by the Bank.

[An] assumption in the forecast about which there is substantial uncertainty is of the equilibrium unemployment rate – or U* for short. Since I have been on the MPC, the Committee has assumed that U* was around 5%. This implied that the more by which unemployment exceeded 5%, the more slack existed in the economy, and the less upward momentum would be expected in wages (controlling for other factors, such as productivity growth).

As part of our annual assessment of regular supply-side conditions this January, Bank staff presented several pieces of analysis that suggested U* may be lower than 5% today [see, for example]. The majority of the MPC voted to lower our estimate of U* to 4.5%, based partly on the persistent weakness of wage growth over the past few years after accounting for other factors in our models. [See page 20 of the February 2017 Inflation Report.]

My own assessment, however, suggested that although U* was likely lower than 5% today, it is likely not as low as 4.5%. If true, this would suggest that there is less slack in the economy than in the MPC’s central forecast, and wage growth and inflation could pick up faster than expected.

Against that, however, uncertainty related to Brexit negotiations could make firms more cautious about raising wages, thereby dampening wage growth no matter where unemployment is relative to its equilibrium. Moreover, even if we could accurately measure the level of U* in the economy today, it could easily change over the next few years as the labour force adjusts to any changes in the movement of labour between the UK and European Union.

Determining the precise figure of the current natural rate of unemployment, and predicting it for the medium term, is very difficult. It involves separating out demand-side factors, which are heavily dependent on expectations. It also involves understanding the wage elasticity of labour supply in various markets and how this has been affected by the increased flexibility of these markets.

Articles

When will Britons get a pay rise? The Guardian, Phillip Inman (26/2/17)
BoE decision, Inflation Report – Analysts react DigitalLook, Alexander Bueso (2/2/17)
Bank of England hikes UK economic growth forecasts but warns of rising inflation The Telegraph, Szu Ping Chan (2/2/17)

Bank of England publications

Inflation Report Bank of England (February 2017)
A MONIAC (not manic) economy Bank of England Speeches, Kristin Forbes (8/2/17)
The labour market Bank of England Speeches, Michael Saunders (31/1/17)

Questions

  1. Distinguish between the following terms: natural rate of unemployment, NAIRU, equilibrium rate of unemployment, disequilibrium rate of unemployment.
  2. For what reasons did the Monetary Policy Committee members feel that the equilibrium rate of unemployment might be as low as 4.25%?
  3. Why might it be as high as 5%?
  4. How are changes in migration trends likely to affect (a) wage growth and (b) unemployment?
  5. How is the amount of slack in an economy measured? What impact does the degree of slack have on wage growth and inflation?
  6. What is meant by the ‘gig’ economy? How has the development of the gig economy impacted on unemployment and wages?
  7. Why has there been a considerable rise in self employment?
  8. How may questions of life style choice and control over the hours people wish to work impact on the labour market?
  9. If people are moving jobs less frequently, does this imply that the labour market is becoming less flexible?
  10. Why may firms in the current climate be cautious about raising wages even if aggregate demand picks up?