Aggregate demand has been booming as the world bounces back from the pandemic. At the same time, aggregate supply is severely constrained. These supply constraints are making potential national income smaller – at least temporarily. The result is that many countries are heading for recession.
At the same time, supply constraints are causing prices to rise, especially energy and food prices. This cost-push inflation is made worse by the rises in aggregate demand.
The result is ‘stagflation’ – a recession, or stagnation, accompanied by high inflation. In the UK, the latest Bank of England Monetary Policy Report forecast that by the end of 2022, CPI inflation would be 13.1% and that in 2023, real GDP would fall by 1.5%.
This effect of an adverse supply shock accompanied by relatively buoyant aggregate demand (at least initially) can be illustrated with an aggregate demand and supply diagram. The supply shock is illustrated by an upward shift to the left of the short-run aggregate supply curve (SRAS). (If the shock is a direct rise in prices, then it can be seen as a vertical upward shift. If it is a fall in the total amount supplied, then it can be seen as a horizontal leftward shift.) In the diagram, aggregate supply shifts from SRAS1 to SRAS2. The price level rises from P1 to P2. If costs go on rising or supply goes on falling then the curve will go on shifting upwards to the left.
If the government responds by increasing benefits or reducing taxes, then, other things being
equal, aggregate demand will rise. In the diagram, the AD curve will shift to the right, e.g. from AD1 to AD2. Real GDP only falls to Y3 not Y2. However, the price level rises further: from P2 to P3.
Why has aggregate supply fallen?
There are several factors that have contributed to the fall in aggregate supply/rise in costs.
- Stretched supply chains, which had been adversely affected by Covid. Congestion at container ports has led to delays, with warehouses and shops being short of stock.
- Labour shortages, with many people not returning to the labour force after being laid off or furloughed, or only returning part time, leaving firms needing more people. The problem has been particularly acute in the UK, with many EU citizens having returned to the EU after Brexit and the UK having to rely increasingly on staff from outside the EU.
The war in Ukraine. This has had a major impact on the supply of natural gas and oil. The war has also led to a fall in grain and other food supplies from Ukraine, as ports have been blockaded and there have been disruptions to planting and harvesting.- Climate change is causing more severe weather events, such as droughts in Europe and western USA. The droughts of 2022 will compound the problem of food shortages and food price inflation.
- In the UK, Brexit costs, such as increased administrative burdens and difficulties in both exporting and importing, have dampened production and hence adversely impacted on aggregate supply.
- Increased industrial action. As the cost of living soars, unions are demanding pay increases to match the rise in the cost of living. Pay rises further increase firms’ costs – and the bigger the pay rises, the bigger the rise in costs.
The problem with a fall in aggregate supply is that it reduces real GDP. People as a whole are poorer. To use a common analogy, the national ‘pie’ has shrunk. Giving everyone a bigger knife and fork (i.e. a rise in nominal aggregate demand) will not make people better off. It just compounds the problem of rising prices, as the diagram shows.
In the short term, with GDP shrinking, there is a major issue of distribution. If the poor are to be given help so that they are not made even poorer, then other people will have been made worse off. In other words, their nominal incomes must rise more slowly than prices.
Monetary policy
Central banks generally have a mandate of keeping inflation close to 2% over the medium term. Their levers are changes in interest rates, underpinned by changes in the money supply – in extreme times by quantitative easing (creating money by buying assets with newly created money) or quantitative tightening (withdrawing money from the economy by selling assets). Central banks, faced by soaring inflation, have been raising interest rates. The Fed has recently raised the Federal Funds rate by 0.75 percentage points (75 basis points) and the Bank of England and the European Central Bank by 0.5 percentage points (50 basis points).
Raising interest rates reduces inflation by dampening aggregate demand. In the diagram, the AD curve shifts to the left (or shifts to the right less quickly). This will dampen inflation, as falling real demand will force firms to cut prices. But it will also force them to cut output and employment, thereby worsening the recession.
Central banks recognise this dilemma, but also recognise that if inflation is not brought rapidly under control, it could spiral upwards, with wages and prices chasing each other in a wage–price spiral, which only gets worse as inflationary expectations rise. The short-term pain of falling real income is a price worth paying for getting inflation under control.
Fiscal policy
In the short term, there is little that fiscal policy can do to raise real GDP. The focus, as it was during the pandemic, must therefore be in providing relief to those most in need.
In the UK, the energy price cap set by Ofgem will see likely energy bills for the typical household quadruple in just a year, from a little over £1000 per annum at January 2021 prices to over £4200 in predicted January 2023 prices. These higher prices partly reflect rising wholesale energy costs and partly the need for energy companies, in a process known as ‘backwardation’, to recoup hedging costs they have incurred so as not to be forced out of business.
Relief for consumers can be in various forms. For example, the government could pay subsidies to energy suppliers to cap prices at a lower level, perhaps just for the poorest households. Or it could pay grants to help people with their bills. Again, these could be targeted to the poorest families, or paid on a sliding scale according to income. Or VAT on gas and electricity could be scrapped.
Generally the more people are entitled to help, the more expensive it is for the government and hence the less generous the help per family is likely to be.
Then there is the question of whether such measures should be accompanied by a rise in broadly-based tax, such as income tax, or whether the government should borrow more, which would be likely to push up interest rates and increase the cost of servicing government debt.
One topic of debate in the Conservative leadership contest is whether taxes should be cut to help people struggling with the cost of living. Whilst such a policy, if carefully targeted to investment, might increase aggregate supply over the longer term, in the short term it will increase aggregate demand and will add to inflationary pressures.
Targeting tax cuts to the poor is difficult. Cutting income tax rates has the opposite effect. The rich pay more income tax than the poor and will benefit most from a cut in rates. An alternative is to raise personal allowances. This will provide a bigger percentage help to income taxpayers on lower incomes, but provides no help at all for the poorest people who currently pay no income tax.
Conclusion
The supply shocks are making countries poorer. The focus in the short term, therefore, needs to be on income distribution and how to help those suffering the most.
To end on a note of optimism: the energy shocks are causing governments to invest in alternative sources, such as wind, solar and nuclear. When these come on line, it is expected that energy prices will fall.
As far as overall inflation is concerned, although the Bank of England is forecasting CPI inflation of 13.1% by Q4 2022, it is also forecasting that this will have fallen to 5.5% by Q4 2023 and to just 0.8% by Q3 2024. Fingers crossed.
World politicians, business leaders, charities and pressure groups are meeting in Davos at the 2022 World Economic Forum. Normally this event takes place in January each year, but it was postponed to this May because of Covid-19 and is the first face-to-face meeting since January 2020.
The meeting takes place amid a series of crises facing the world economy. The IMF’s Managing Director, Kristalina Georgieva, described the current situation as a ‘confluence of calamities’. Problems include:
- Continuing hangovers from Covid have caused economic difficulties in many countries.
- The bounceback from Covid has led to demand outpacing supply. The world is suffering from a range of supply-chain problems and shortages of key materials and components, such as computer chips.
- The war in Ukraine has not only caused suffering in Ukraine itself, but has led to huge energy and food price increases as a result of sanctions and the difficulties in exporting wheat, sunflower oil and other foodstuffs.
- Supply shocks have led to rising global inflation. This will feed into higher inflationary expectations, which will compound the problem if they result in higher prices and wages in response to higher costs.
- Central banks have responded by raising interest rates. These dampen an already weakened global economy and could push the world into recession.
- Global inequality is rising rapidly, both within countries and between countries, as Covid disruptions and higher food and energy prices hit the poor disproportionately. Poor people and countries also have a higher proportion of debt and are thus hit especially hard by higher interest rates.
- Global warming is having increasing effects, with a growing incidence of floods, droughts and hurricanes. These lead to crop failures and the displacement of people.
- Countries are increasingly resorting to trade restrictions as they seek to protect their own economies. These slow economic growth.
World leaders at Davos will be debating what can be done. One approach is to use fiscal policy. Indeed, Kristalina Georgieva said that her ‘main message is to recognise that the world must spend the billions necessary to contain Covid in order to gain trillions in output as a result’. But unless the increased expenditure is aimed specifically at tackling supply shortages and bottlenecks, it could simply add to rising inflation. Increasing aggregate demand in the context of supply shortages is not the solution.
In the long run, supply bottlenecks can be overcome with appropriate investment. This may require both greater globalisation and greater localisation, with investment in supply chains that use both local and international sources.
International sources can be widened with greater investment in manufacturing in some of the poorer developing countries. This would also help to tackle global inequality. Greater localisation for some inputs, especially heavier or more bulky ones, would help to reduce transport costs and the consumption of fuel.
With severe supply shocks, there are no simple solutions. With less supply, the world produces less and becomes poorer – at least temporarily until supply can increase again.
Articles
Discussion (video)
Report
Questions
- Draw an aggregate demand and supply diagram (AD/AS or DAD/DAS) to illustrate the effect of a supply shock on output and prices.
- Give some examples of supply-side policies that could help in the current situation.
- What are the arguments for and against countries using protectionist policies at the current time?
- What policies could countries adopt to alleviate rapid rises in the cost of living for people on low incomes? What problems do these policies pose?
- What are the arguments for and against imposing a windfall tax on energy companies and using the money to support poor people?
- If the world slips into recession, should central banks and governments use expansionary monetary and fiscal policies?
As we saw in Part 1, households are seeing a rise in the cost of living, which is set to accelerate. Inflation in the year to January 2022, as measured by the Consumer Prices Index (CPI), was 5.5%, the highest rate for over 30 years, and it is expected to reach more than 7 per cent by April. This has put great pressure on household budgets, with wage rises for most people being below the rate of price inflation. The poor especially have been hard hit, with many struggling to meet soaring energy, food and transport prices and higher rents.
In Part 2 we look at the UK government’s response to the situation, a similar response to that in many other countries.
Effects on government finances
The Chancellor, Rishi Sunak, has stated that the government understands the pressures families are facing with the cost of living. However, rising interest rates mean that it will cost the Treasury considerably more to service the UK’s national debt of more than £2tn.
Interest payments on index-linked debt are calculated using an alternative measure of inflation, the retail prices index (RPI), which is running at 7.8%, considerably higher than anticipated in last October’s Budget. It is now projected that central government spending on debt interest this financial year will come in at around £69bn, some £11bn higher than the £58bn forecast in the October 2021 Budget and £27bn above the £42bn forecast in the March 2021 Budget.
In addition, it is expected that the latest rise in CPI will increase the chances of the Bank of England raising interest rates and thereby further increasing the costs of servicing national debt. If this is the outcome when its Monetary Policy Committee meets next month, then it would be the third successive time interest rates have been raised.
There is also concern that this, in addition to the direct effects of higher costs, will push more firms towards insolvency. It is argued that if government wanted to prevent this, it would need to cut business taxes in order to boost investment and productivity and to allow businesses to provide annual wage rises that are affordable.
Monetary policy
The Bank of England’s traditional response to rising inflation is to raise interest rates, which it has done this twice in the past few months. This means that people who have borrowed money could see their monthly payments go up, especially on mortgages tied to Bank Rate.
An aim of this policy is to make borrowing more expensive resulting in people spending less. As a result, they will buy fewer things, and prices will stop rising as fast. However, when inflation is caused by external forces, this might have a limited effect on prices and would put a further squeeze on household budgets.
Fiscal policy
Alternatively, the government might choose to cut taxes for consumers on items whose prices are rising quickly. It is taking some measures to reduce the impact of energy price rises. For example, the Treasury has announced that it would provide millions of households with up to £350 to help with their rising energy bills and in April the lowest-paid will see the National Living Wage rise by 6.6%, which is higher than the current inflation rate.
The chief economist of the British Chambers of Commerce has said that tightening monetary policy too quickly risks undermining confidence and the wider recovery, arguing that more needs to be done to limit the unprecedented rise in costs facing businesses, including financial support for those struggling with soaring energy bills and delaying April’s national insurance rise.
Conclusion
Rising inflation affects all our living standards. It a global issue with causes beyond government control.
Rising prices together with planned tax increases mean that real average take-home pay is likely to fall over the coming year. The extra energy costs and tax rises will force families to make savings elsewhere, meaning business revenues may fall, and the economic recovery could be negatively impacted.
However, it is those on low incomes that tend to find it hardest to cope with the rising cost of living. Those impacted the most will be faced with difficult decisions over the coming months as they try to cope with falling real incomes. With food price inflation expected to rise further, a likely rise in interest rates and a further increase in the energy price cap in October, these tough decisions are set to get harder for poorest households in the economy.
Articles
See articles in Part 1
Podcast
Questions
These questions are based on the podcast.
- What elements are there in household energy prices? Which element has gone up most?
- What are the arguments for and against the government delaying the rise in the rate of national insurance by 1.25 percentage points?
- What can be done to help people on modest earnings who earn just too much to receive benefits?
- Are government loans to help people with higher bills a good idea?
- What are the advantages and disadvantages of removing VAT on domestic energy?
During the pandemic, millions of people’s wages in the UK were paid by the government to prevent the closure of businesses and a surge in unemployment. The furlough scheme officially came to an end in September 2021. However, with the spread of the Omicron variant and the fear of further restrictions being put in place, there has been a call by many to re-introduce the furlough scheme.
The furlough scheme
The furlough scheme began when the government brought in, what was officially called the Coronavirus Job Retention Scheme (CJRS) in early 2020. This was when the pandemic first forced businesses across the country to close. The scheme worked by paying part of employees’ wages, preventing the need for businesses to make their staff redundant, therefore avoiding a rapid rise in unemployment along with the associated costs. It also avoided the financial and emotional costs of firing and then rehiring workers post pandemic. Under the scheme, furloughed workers received 80% of their wages, up to £2500 a month, if they couldn’t work because of the impact of coronavirus. Employees were able to maintain the security of employment and the payments helped furloughed workers pay their bills.
The scheme saw billions of pounds spent paying the wages of employees whose firms were forced to close temporarily. It could be argued that the expense of the scheme was a huge disadvantage. However, the alternative would have been for the government to pay unemployment-related benefits. Despite the furlough scheme being deemed necessary, it was not without its drawbacks for the structure of businesses. Rather than businesses adapting to changes in the economy and consumer demands, they could decide to claim the money and avoid the need to restructure. There was also concern about the length of the furlough scheme and the ability of businesses to bounce back post-pandemic.
Since the start of the scheme, the specifics of what was paid and who received it changed over time, especially once the economy started opening again. Initial steps were made to allow part-time return to work and the scheme started to wind down over the summer of 2021, with the government covering less of the wages and businesses covering more. From July, employers had to provide 10% of the wages of their furloughed staff, with the government paying the rest. This then increased to 20% in August with the CJRS coming to a complete end on 30 September 2021. At this point, there were around 1.6 million employees still receiving payment from the scheme.
Impact on Employment
With the end to the furlough scheme in September 2021, there were concerns that this would lead to a large number of redundancies. However, data indicate that has not happened and there is a record number of job vacancies. Official figures show that UK employment rose in October, confirming the strength of the labour market. The Office for National Statistics stated that the employment rate rose to 75.5% in the three months to October, up 0.2 percentage points on the previous quarter. This is believed to be driven by a rise in part-time work, which had dropped sharply during the pandemic. However, it is important to note that the strength in these numbers was prior to the emergence of the Omicron variant.
Omicron
In November, the government had ruled out once again bankrolling people’s wages at enormous expense. However, the Chancellor is now under pressure to respond to the latest announcements around the ever-changing landscape of the pandemic. The fast-spreading mutation of the Covid-19 virus, Omicron, is posing a fresh threat to the economy.
On the 8 December, the Prime Minister announced new ‘Plan B’ Covid rules for England. As part of these new rules to limit the spread of Omicron, people are being asked to work from home again if possible and face masks are compulsory in most public places. Covid passes or a negative Covid test result are also needed to get into nightclubs and large venues.
Scotland and Wales have brought in further restrictions. Scotland’s First Minister, Nicola Sturgeon, has asked people to limit socialising to three households at a time in the run-up to Christmas. Shops and hospitality venues in Scotland must bring back physical distancing and screens. In Wales, nightclubs will close after 26 December and social distancing will be reintroduced in shops.
Although the hospitality industry and retail sector remain open, they are facing a slump in trade thanks to the new restrictions and worries among the general public. With the work-from-home guidance and advice from health officials that people should limit their social interactions, pubs and restaurants have seen widespread cancellations in the run-up to Christmas. Trade is suffering and these mass cancellations come at a time when these sectors were hoping for bumper trade after a dismal last couple of years.
In light of these concerns, ministers are now being urged to guarantee support in case businesses have to shut. Despite the indication that it would be highly unlikely that the UK would experience a full return to the restrictions seen at previous stages of the crisis, the International Monetary Fund has stated that the UK government should be drawing up contingency plans. The IMF has called for a mini-furlough scheme in the event that the Omicron variant forces the government to close parts of the economy. The idea is that the mini-furlough scheme would see a limited version of the multi-billion-pound job subsidy scheme being rolled out if firms are forced to close.
There are strong calls for there to be targeted support, which this mini-furlough scheme could offer. The Resolution Foundation argued in mid-December that a furlough scheme tied solely to the hospitality industry would help prevent job loses in an industry that is currently suffering once again. It calculated that the cost of a hospitality-only furlough scheme would be £1.4 billion a month if it were pitched at the original level of 80% of wage support. If a January to March sector-specific scheme were to be introduced it is estimated to cost around £5 billion, a small cost in comparison to £46 billion spent on furlough so far.
Inflation
Any reintroduction of a furlough scheme would be a jolt for the government. This would mean a return to the 2020-style arguments around protecting livelihoods and businesses, a contrast to the recent messaging from the Treasury of restoring public finances. There is also concern about how this will all impact on current growth predictions and inflation concerns. The IMF expects the growth of the UK economy to be 6.8% in 2021 and 5% in 2022. However, the drawback from this is that the recovery would also be accompanied by rising inflation. It has been suggested, therefore, that interest rate increases from the Bank of England would be needed to keep inflation under control, while at the same time being not so great as to kill off growth.
It was widely expected that the Bank of England would again put off a rate hike in order to wait to see the economic impact of Plan B restrictions. However, on Thursday 16 December, interest rates were raised for the first time in more than three years. Despite the fears that Omicron could slow the economy by causing people to spend less, Bank Rate was raised from 0.1% to 0.25% . This came in the wake of data showing prices climbing at the fastest pace for 10 years.
Next Steps?
Government finances would take another huge hit if the furlough scheme were revived. But a version of such a scheme is likely to be necessary to avert an unemployment crisis and the attendant costs.
However, in resisting further measures, the government has argued that it has already acted early to help control the virus’s spread by rapidly rolling out booster jabs, while avoiding unduly damaging economic and social restrictions.
The government also argues that some of the measures from the total £400 billion Covid support package since the start of the pandemic will continue to help businesses into Spring 2022. Such measures include government-backed loans for small- and medium-sized businesses until June 2022, a reduction in VAT from 20% to 12.5% until March 2022 and business rates relief for eligible retail, hospitality, and leisure businesses until March 2022. Talks are ongoing with hospitality and and other business organisations directly affected by Covid restrictions.
The British Chambers of Commerce has argued that current measures are not enough and has called for VAT on hospitality and tourism to be cut back to its emergency rate of 5% and for the 100% business rates relief for retailers to return. The CBI has also called for any unspent local authority grants to be spent now to help affected firms and that further help, including business rates relief, should be on the table if restrictions continue after the government’s 5 January review date. The IMF said that with strong policy support, the economy had proved resilient, but it stressed that a return of some of the measures that prevented mass unemployment and large-scale business failures might soon be needed.
Conclusion
Infections caused by the new Omicron variant are rising rapidly, doubling every two to three days. It is expected to become the dominant variant in the UK soon with health officials warning it may be the most significant threat since the start of the pandemic. However, it is not yet known what the full extent of the impact of this new variant on the NHS will be, leaving the severity of future restrictions uncertain.
But what is evident is that the course of the pandemic has changed and there is a growing case for the government to start planning for new support packages. Although a reintroduction of the furlough scheme was hoped not to be needed on the path out of the pandemic, a short detour may be required in the form of a mini-furlough scheme. The size and reach of any support put in place will depend upon any further restrictions on economic activity.
Articles
Questions
- Should the level of support for business return to the levels in place earlier in 2021?
- What measures could a government put in place to curtail the spread of the Omicron variant that have only a minimal impact on business and employment?
- Compare the UK measures to curtail the spread of the virus with those used in some other European countries.
- What are the arguments for and against (a) re-introducing the furlough scheme as it was earlier in 2021; (b) introducing a version restricted to the hospitality sector?
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.
Data and Reports
Articles
Questions
- What do you understand by the term ‘macroeconomic environment’? What data could be used to describe the macroeconomic environment?
- When a country experiences positive rates of inflation, which is higher: nominal economic growth or real economic growth?
- Does an increase in nominal GDP mean a country’s production has increased? Explain your answer.
- Does a decrease in nominal GDP mean a country’s production has decreased? Explain your answer.
- Why does a change in the growth of real GDP allow us to focus on what has happened to the volume of production?
- What does the concept of the ‘business cycle’ have to do with real rates of economic growth?
- When would falls in real GDP be classified as a recession?
- Distinguish between the concepts of ‘short-term growth rates’ and ‘longer-term growth’.
- What do you understand by the term hysteresis? By what means can hysteresis effects be generated?
- 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.
July 26-27, 2022 FOMC Meeting, Chair Powell’s Press Conference