The following blog is inspired by my teaching of macroeconomic issues to my final year students at Aston University. In the classes we’ve been discussing important aspects of monetary and fiscal policy design. What has become clear to me and my students is that the trade-offs which characterise the discipline of economics are certainly alive and well in the current environment in which monetary and fiscal policy choices are being made.
To demonstrate this we consider here some of the discussions we’ve had in class around central bank independence and monetary policy mandates. We’ve also looked at fiscal policy. Here we’ve examined the state of the public finances and the importance that seems to be attached to debt stabilisation and the imposition of debt rules.
Delegation and central bank mandates
My teaching this term began by introducing my students to one of the most important and influential monetary policy models. This is the model of Kydland and Prescott. Their model, published in the Journal of Political Economy in 1977 has become the theoretical bedrock for the modern-day operational independence of central banks.1
The model explores how systemically high inflation can become established in economies when policymakers have the political incentive to lower unemployment or increase output above its long-run equilibrium value. This may be the case if governments operate monetary policy rather than the central bank (of if the central bank operates monetary policy but follows government objectives). By adopting expansionary monetary policy, governments can increase their popularity.
But this is likely to be short-lived, as any increased economic activity will only be temporary (assuming that the natural-rate hypothesis holds). Soon, inflation will rise.
But, if an election is on the horizon, there may be enough time to boost output and employment before inflation rises. In other words, an expectations-augmented Phillips curve may present governments with an incentive to loosen monetary policy and worry about the inflation consequences after the election.
However, the resulting ‘inflation surprise’ through the loosening of monetary policy means a fall in real pay and therefore in purchasing power. If people suspect that governments will be tempted to loosen policy, they will keep their expectations of inflation higher than the socially optimal inflation rate. Consequently, low-inflation targets lack credibility when governments have the temptation to loosen monetary policy. Such targets are time-inconsistent because governments have an incentive to renege and deliver higher inflation through a looser monetary policy. The result is an inflation bias.
Central bank independence
To prevent this inflationary bias arising, many central banks around the world have been given some form of operational independence with a mandate centred around an inflation-rate target. By delegating monetary policy to a more conservative central bank, the problem of inflationary bias can be addressed.
Yet central bank independence is not without its own issues and this has been an important part of the discussions with my students. Today, many economies are continuing to experience the effects of the inflationary shocks that began in 2021 (see Chart 1 for the UK CPI inflation rate: click here for a PowerPoint). The question is whether the appointment of a conservative or hard-nosed hawkish central banker trades off the stabilisation of inflation for greater volatility in output or unemployment.
The inflation–output stabilisation trade-off is closely associated with the works of Kenneth Rogoff2 and John Taylor3. The latter is known for his monetary policy rule, which has become known as the ‘Taylor rule’. This advocates that a rules-based central bank ought to place weight on both inflation and output stabilisation.
This is not without its own issues, however, since, by also placing weight on output stabilisation, we are again introducing the possibility of greater inflationary bias in policy making. Hence, while the act of delegation and a rules- or target-based approach may mitigate the extent of the bias relative to that in the Kydland and Prescott model, there nonetheless still remain issues around the design of the optimal framework for the conduct of monetary policy.
Indeed, the announcement that the UK had moved into recession in the last two quarters of 2023 can be seen as evidence that an otherwise abstract theoretical trade-off between inflation and output stabilisation is actually very real.
My classroom discussions have also shown how economic theory struggles to identify an optimal inflation-rate target. Beyond accepting that a low and stable inflation rate is desirable, it is difficult to address fully the student who asks what is so special about a 2% inflation target. Would not a 3% target, for example, be preferable, they might ask?
Whilst this may sound somewhat trivial, it has real-world consequences. In a world that now seems to be characterised by greater supply-side volatility and by more frequent inflation shocks than we were used to in recent history, might a higher inflation rate target be preferable? Certainly, one could argue that, with an inflation–output stabilisation trade-off, there is the possibility that monetary policy could be unduly restrictive in our potential new macroeconomic reality. Hence, we might come to see governments and central banks in the near future revisiting the mandates that frame the operation of their monetary policy. Time will tell.
Fiscal policy and debt stabilisation
The second topic area that I have been discussing in my final-year macroeconomics classes has centred around fiscal policy and the state of the public finances. The context for this is that we have seen a significant increase in public debt-to-GDP ratios over the past couple of decades as the public sector has attempted to absorb significant economic shocks. These include the global financial crisis of 2007–8, the COVID-19 pandemic and the cost-of-living crisis. These interventions in the case of the UK have seen its public debt-to-GDP ratio more than triple since the early 2000s to close to 100% (see Chart 2: click here for a PowerPoint).
Understandably, given the stresses placed on the public finances, economists have increasingly debated issues around debt sustainability. These debates have been mirrored by politicians and policymakers. A key question is whether to have a public debt rule. The UK has in recent years adopted such a rule. The arguments for a rule centre on ensuring sound public finances and maintaining the confidence of investors to purchases public debt. A debt rule therefore places a discipline on fiscal policy, with implications for taxation and spending.
How easy it is to stick to a debt rule depends on three key factors. It will be harder to stick to the rule:
- The higher the current debt-to-GDP ratio and hence the more it needs to be reduced to meet the rule.
- The higher the rate of interest and hence the greater the cost of servicing the public debt.
- The lower the rate of economic growth and hence the less quickly will tax revenues rise.
With a given debt-to-GDP ratio, a given average interest rate payable on its debt, and a given rate of economic growth, we can determine the primary fiscal balance relative to GDP a government would need to meet for the debt-to-GDP ratio to remain stable. This is known as the ‘debt-stabilising primary balance’. The primary balance is the difference between a government’s receipts and its expenditures less the interest payments on its debt.
This fiscal arithmetic is important in determining a government’s fiscal choices. It shows the implications for spending and taxation. These implications become ever more important and impactful on people, businesses, and society when the fiscal arithmetic becomes less favourable. This is a situation that appears to be increasingly the case for many countries, including the UK, as the rate of interest on public debt rises relative to a country’s rate of economic growth. As this happens, governments are increasingly required to run healthier primary balances. This of course implies a tightening of their fiscal stance.
Hence, the fiscal conversations with my students have focused on both the benefits and the costs of debt-stabilisation. In respect of the costs, a few issues have arisen.
First, as with the inflation-rate target, it is hard to identify an optimal public debt-to-GDP ratio number. While the fiscal arithmetic may offer some clue, it is not straightforward to address the question as to whether a debt-to-GDP ratio of say 100% or 120% would be excessive for the UK.
Second, it is possible that the debt stabilisation itself can make the fiscal arithmetic of debt stabilisation more difficult. This occurs if fiscal consolidation itself hinders long-term economic growth, which then makes the fiscal arithmetic more difficult. This again points to the difficulties in designing policy frameworks, whether they be for monetary or fiscal policy.
Third, a focus on debt stabilisation alone ignores the fact that there are two sides to any sector’s balance sheet. It would be very unusual when assessing the well-being of businesses or households if we were to ignore the asset side of their balance sheet. Yet, this is precisely the danger of focusing on public debt at the exclusion of what fiscal choices can mean for public-sector assets, from which we all can potentially benefit. Hence, some would suggest a more balanced approach to assessing the soundness of the public finances might involve a net worth (assets less liabilities) measure. This has parallels with the debates around whether mandates of central banks should be broader.
Applications in macroeconomics
What my teaching of a topics-based macroeconomics module this term has vividly demonstrated is that concepts, theories, and models come alive, and are capable of being understood better, when they are used to shine a light on real-world issues. The light being shone on monetary and fiscal policy in today’s turbulent macroeconomic environment is perhaps understandably very bright.
Indeed, the light being shone on fiscal policy in the UK and some other countries facing an upcoming election, is intensified further with the state of the public finances shaping much of the public discourse on fiscal choices. Hopefully, my students will continue to debate these important issues beyond their graduation, stressing their importance for people’s lives and, in doing so, going beyond the abstract.
References
- Rules rather than discretion: The inconsistency of optimal plans
The Journal of Political Economy, Finn E Kydland and Edward C. Prescott (1977, 85(3), pp 473–92)
- The optimal degree of commitment to an intermediate monetary target
Quarterly Journal of Economics, Kenneth Rogoff (November 1985, 100(4), pp 1169–89)
- Discretion versus policy rules in practice
Carnegie-Rochester Conference Series on Public Policy, John B Taylor (December 1993, 39, pp 195–214)
Articles
Questions
- What is meant by time-inconsistent monetary policy announcements? How has this concept been important for the way in which many central banks now conduct monetary policy?
- What is meant by a ‘conservative’ central banker? Why is the appointment of this type of central banker thought to be important in affecting inflation?
- What is the contemporary macroeconomic relevance of the inflation–output (or inflation–unemployment) stabilisation trade-off?
- How is the primary balance different from the actual budget balance?
- What do you understand by the concept of ‘the fiscal arithmetic’. Explain how each element of the fiscal arithmetic affects the debt-stabilising primary balance?
- Analyse the costs of benefits of a debt-based fiscal rule.
According to the IMF, Chinese GDP grew by 5.2% in 2023 and is predicted to grow by 4.6% this year. Such growth rates would be extremely welcome to most developed countries. UK growth in 2023 was a mere 0.5% and is forecast to be only 0.6% in 2024. Advanced economies as a whole only grew by 1.6% in 2023 and are forecast to grow by only 1.5% this year. Also, with the exception of India, the Philippines and Indonesia, which grew by 6.7%, 5.3% and 5.0% respectively in 2023 and are forecast to grow by 6.5%, 6.0% and 5.0% this year, Chinese growth also compares very favourably with other developing countries, which as a weighted average grew by 4.1% last year and are forecast to grow at the same rate this year.
But in the past, Chinese growth was much higher and was a major driver of global growth. Over the period 1980 to 2018, Chinese economic growth averaged 9.5% – more than twice the average rate of developing countries (4.5%) and nearly four times the average rate of advanced countries (2.4%) (see chart – click here for a PowerPoint of the chart).
Not only is Chinese growth now much lower, but it is set to decline further. The IMF forecasts that in 2025, Chinese growth will have fallen to 4.1% – below the forecast developing-country average of 4.2% and well below that of India (6.5%).
Causes of slowing Chinese growth
There are a number of factors that have come together to contribute to falling economic growth rates – growth rates that otherwise would have been expected to be considerably higher as the Chinese economy reopened after severe Covid lockdowns.
Property market
China has experienced a property boom over the past 20 years years as the government has encouraged construction in residential blocks and in factories and offices. The sector has accounted for some 20% of economic activity. But for many years, demand outstripped supply as consumers chose to invest in property, partly because of a lack of attractive alternatives for their considerable savings and partly because property prices were expected to go on rising. This lead to speculation on the part of both buyers and property developers. Consumers rushed to buy property before prices rose further and property developers borrowed considerably to buy land, which local authorities encouraged, as it provided a valuable source of revenue.
But now there is considerable overcapacity in the sector and new building has declined over the past three years. According to the IMF:
Housing starts have fallen by more than 60 per cent relative to pre-pandemic levels, a historically rapid pace only seen in the largest housing busts in cross-country experience in the last three decades. Sales have fallen amid homebuyer concerns that developers lack sufficient financing to complete projects and that prices will decline in the future.
As a result, many property developers have become unviable. At the end of January, the Chinese property giant, Evergrande, was ordered to liquidate by a Hong Kong court, after the judge ruled that the company did not have a workable plan to restructure around $300bn of debt. Over 50 Chinese property developers have defaulted or missed payments since 2020. The liquidation of Evergrande and worries about the viability of other Chinese property developers is likely to send shockwaves around the Chinese property market and more widely around Chinese investment markets.
Overcapacity
Rapid investment over many years has led to a large rise in industrial capacity. This has outstripped demand. The problem could get worse as investment, including state investment, is diverted from the property sector to manufacturing, especially electric vehicles. But with domestic demand dampened, this could lead to increased dumping on international markets – something that could spark trade wars with the USA and other trading partners (see below). Worries about this in China are increasing as the possibility of a second Trump presidency looks more possible. The Chinese authorities are keen to expand aggregate demand to tackle this overcapacity.
Uncertainty
Consumer and investor confidence are low. This is leading to severe deflationary pressures. If consumers face a decline in the value of their property, this wealth effect could further constrain their spending. This will, in turn, dampen industrial investment.
Uncertainty is beginning to affect foreign companies based in China. Many foreign companies are now making a loss in China or are at best breaking even. This could lead to disinvestment and add to deflationary pressures.
The Chinese stock market and policy responses
Lack of confidence in the Chinese economy is reflected in falling share prices. The Shanghai SSE Composite Index (an index of all stocks traded on the Shanghai Stock Exchange) has fallen dramatically in recent months. From a high of 3703 in September 2021, it had fallen to 2702 on 5 Feb 2024 – a fall of 27%. It is now below the level at the beginning of 2010 (see chart: click here for a PowerPoint). On 5 February alone, some 1800 stocks fell by over 10% in Shanghai and Shenzhen. People were sensing a rout and investors expressed their frustration and anger on social media, including the social media account of the US Embassy. The next day, the authorities intervened and bought large quantities of key stocks. China’s sovereign wealth fund announced that it would increase its purchase of shares to support the country’s stock markets. The SSE Composite rose 4.1% on 6 February and the Shenzhen Component Index rose 6.2%.
However, the rally eased as investors waited to see what more fundamental measures the authorities would take to support the stock markets and the economy more generally. Policies are needed to boost the wider economy and encourage a growth in consumer and business confidence.
Interest rates have been cut four times since the beginning of 2022, when the prime loan rate was cut from 3.85% to 3.7%. The last cut was from 3.55% to 3.45% in August 2023. But this has been insufficient to provide the necessary boost to aggregate demand. Further cuts in interest rates are possible and the government has said that it will use proactive fiscal and effective monetary policy in response to the languishing economy. However, government debt is already high, which limits the room for expansionary fiscal policy, and consumers are highly risk averse and have a high propensity to save.
Graduate unemployment
China has seen investment in education as an important means of increasing human capital and growth. But with a slowing economy, there are are more young people graduating each year than there are graduate jobs available. Official data show that for the group aged 16–24, the unemployment rate was 14.9% in December. This compares with an overall urban unemployment rate of 5.1%. Many graduates are forced to take non-graduate jobs and graduate jobs are being offered at reduced salaries. This will have a further dampening effect on aggregate demand.
Demographics
China’s one-child policy, which it pursued from 1980 to 2016, plus improved health and social care leading to greater longevity, has led to an ageing population and a shrinking workforce. This is despite recent increases in unemployment in the 16–24 age group. The greater the ratio of dependants to workers, the greater the brake on growth as taxes and savings are increasingly used to provide various forms of support.
Effects on the rest of the world
China has been a major driver of world economic growth. With a slowing Chinese economy, this will provide less stimulus to growth in other countries. Many multinational companies, including chip makers, cosmetics companies and chemical companies, earn considerable revenue from China. For example, the USA exports over $190 billion of goods and services to China and these support over 1 million jobs in the USA. A slowdown in China will have repercussions for many companies around the world.
There is also the concern that Chinese manufacturers may dump products on world markets at less than average (total) cost to shift stock and keep production up. This could undermine industry in many countries and could initiate a protectionist response. Already Donald Trump is talking about imposing a 10% tariff on most imported goods if he is elected again in November. Such tariffs could be considerably higher on imports from China. If Joe Biden is re-elected, he too may impose tariffs on Chinese goods if they are thought to be unfairly subsidised. US (and possibly EU) tariffs on Chinese goods could lead to a similar response from China, resulting in a trade war – a negative sum game.
Videos
Articles
- IMF Predicts China Economy Slowing Over Next Four Years
Voice of America, Evie Steele (2/2/24)
- China’s Real Estate Sector: Managing the Medium-Term Slowdown
IMF News, Henry Hoyle and Sonali Jain-Chandra (2/2/24)
- China braced for largest human migration on earth amid bleak economic backdrop
ITV News, Debi Edward (4/2/24)
- China’s property giant Evergrande ordered to liquidate as debt talks fail
Aljazeera (29/1/24)
- China’s overcapacity a challenge that is ‘here to stay’, says US chamber
Financial Times, Joe Leahy (1/2/24)
- China needs to learn lessons from 1990s Japan
Financial Times, Gillian Tett (1/2/24)
- The Trump factor is looming over China’s markets
Financial Times, Katie Martin (2/2/24)
- China’s many systemic problems dominate its outlook for 2024
The Guardian, George Magnus (1/1/24)
- China youth unemployment will stay elevated in 2024, but EIU warns economic impact will linger
CNBC, Clement Tan (25/1/24)
- Don’t count on a soft landing for the world economy – turbulence is ahead
The Guardian, Kenneth Rogoff (2/2/24)
- As falling stocks draw criticism in China, censors struggle to keep up
Washington Post, Lily Kuo (6/2/24)
- China’s doom loop: a dramatically smaller (and older) population could create a devastating global slowdown
The Conversation, Jose Caballero (12/2/24)
- China: why the country’s economy has hit a wall – and what it plans to do about it
The Conversation, Hong Bo (19/3/24)
- Confronting inflation and low growth
OECD Economic Outlook Interim Report (September 2023) (see especially Box 1)
Questions
- Why is China experiencing slowing growth and is growth likely to pick up over the next five years?
- How does the situation in China today compare with that in Japan 30 years ago?
- What policies could the Chinese government pursue to stimulate economic growth?
- What policies were enacted towards China during the Trump presidency from 2017 to 2020?
- Would you advise the Chinese central bank to cut interest rates further? Explain.
- Should China introduce generous child support for families, no matter the number of children?
Artificial intelligence is having a profound effect on economies and society. From production, to services, to healthcare, to pharmaceuticals; to education, to research, to data analysis; to software, to search engines; to planning, to communication, to legal services, to social media – to our everyday lives, AI is transforming the way humans interact. And that transformation is likely to accelerate. But what will be the effects on GDP, on consumption, on jobs, on the distribution of income, and human welfare in general? These are profound questions and ones that economists and other social scientists are pondering. Here we look at some of the issues and possible scenarios.
According to the Merrill/Bank of America article linked below, when asked about the potential for AI, ChatGPT replied:
AI holds immense potential to drive innovation, improve decision-making processes and tackle complex problems across various fields, positively impacting society.
But the magnitude and distribution of the effects on society and economic activity are hard to predict. Perhaps the easiest is the effect on GDP. AI can analyse and interpret data to meet economic goals. It can do this much more extensively and much quicker than using pre-AI software. This will enable higher productivity across a range of manufacturing and service industries. According to the Merrill/Bank of America article, ‘global revenue associated with AI software, hardware, service and sales will likely grow at 19% per year’. With productivity languishing in many countries as they struggle to recover from the pandemic, high inflation and high debt, this massive boost to productivity will be welcome.
But whilst AI may lead to productivity growth, its magnitude is very hard to predict. Both the ‘low-productivity future’ and the ‘high-productivity future’ described in the IMF article linked below are plausible. Productivity growth from AI may be confined to a few sectors, with many workers displaced into jobs where they are less productive. Or, the growth in productivity may affect many sectors, with ‘AI applied to a substantial share of the tasks done by most workers’.
Growing inequality?
Even if AI does massively boost the growth in world GDP, the distribution is likely to be highly uneven, both between countries and within countries. This could widen the gap between rich and poor and create a range of social tensions.
In terms of countries, the main beneficiaries will be developed countries in North America, Europe and Asia and rapidly developing countries, largely in Asia, such as China and India. Poorer developing countries’ access to the fruits of AI will be more limited and they could lose competitive advantage in a number of labour-intensive industries.
Then there is growing inequality between the companies controlling AI systems and other economic actors. Just as companies such as Microsoft, Apple, Google and Meta grew rich as computing, the Internet and social media grew and developed, so these and other companies at the forefront of AI development and supply will grow rich, along with their senior executives. The question then is how much will other companies and individuals benefit. Partly, it will depend on how much production can be adapted and developed in light of the possibilities that AI presents. Partly, it will depend on competition within the AI software market. There is, and will continue to be, a rush to develop and patent software so as to deliver and maintain monopoly profits. It is likely that only a few companies will emerge dominant – a natural oligopoly.
Then there is the likely growth of inequality between individuals. The reason is that AI will have different effects in different parts of the labour market.
The labour market
In some industries, AI will enhance labour productivity. It will be a tool that will be used by workers to improve the service they offer or the items they produce. In other cases, it will replace labour. It will not simply be a tool used by labour, but will do the job itself. Workers will be displaced and structural unemployment is likely to rise. The quicker the displacement process, the more will such unemployment rise. People may be forced to take more menial jobs in the service sector. This, in turn, will drive down the wages in such jobs and employers may find it more convenient to use gig workers than employ workers on full- or part-time contracts with holidays and other rights and benefits.
But the development of AI may also lead to the creation of other high-productivity jobs. As the Goldman Sachs article linked below states:
Jobs displaced by automation have historically been offset by the creation of new jobs, and the emergence of new occupations following technological innovations accounts for the vast majority of long-run employment growth… For example, information-technology innovations introduced new occupations such as webpage designers, software developers and digital marketing professionals. There were also follow-on effects of that job creation, as the boost to aggregate income indirectly drove demand for service sector workers in industries like healthcare, education and food services.
Nevertheless, people could still lose their jobs before being re-employed elsewhere.
The possible rise in structural unemployment raises the question of retraining provision and its funding and whether workers would be required to undertake such retraining. It also raises the question of whether there should be a universal basic income so that the additional income from AI can be spread more widely. This income would be paid in addition to any wages that people earn. But a universal basic income would require finance. How could AI be taxed? What would be the effects on incentives and investment in the AI industry? The Guardian article, linked below, explores some of these issues.
The increased GDP from AI will lead to higher levels of consumption. The resulting increase in demand for labour will go some way to offsetting the effects of workers being displaced by AI. There may be new employment opportunities in the service sector in areas such as sport and recreation, where there is an emphasis on human interaction and where, therefore, humans have an advantage over AI.
Another issue raised is whether people need to work so many hours. Is there an argument for a four-day or even three-day week? We explored these issues in a recent blog in the context of low productivity growth. The arguments become more compelling when productivity growth is high.
Other issues
AI users are not all benign. As we are beginning to see, AI opens the possibility for sophisticated crime, including cyberattacks, fraud and extortion as the technology makes the acquisition and misuse of data, and the development of malware and phishing much easier.
Another set of issues arises in education. What knowledge should students be expected to acquire? Should the focus of education continue to shift towards analytical skills and understanding away from the simple acquisition of knowledge and techniques. This has been a development in recent years and could accelerate. Then there is the question of assessment. Generative AI creates a range of possibilities for plagiarism and other forms of cheating. How should modes of assessment change to reflect this problem? Should there be a greater shift towards exams or towards project work that encourages the use of AI?
Finally, there is the issue of the sort of society we want to achieve. Work is not just about producing goods and services for us as consumers – work is an important part of life. To the extent that AI can enhance working life and take away a lot of routine and boring tasks, then society gains. To the extent, however, that it replaces work that involved judgement and human interaction, then society might lose. More might be produced, but we might be less fulfilled.
Articles
- The Macroeconomics of Artificial Intelligence
IMF publications, Erik Brynjolfsson and Gabriel Unger (December 2023)
- Economic impacts of artificial intelligence (AI)
European Parliamentary Research Service, Marcin Szczepański (July 2019)
- Artificial intelligence: A real game changer
Chief Investment Office, Merrill/Bank of America (July 2023)
Generative AI could raise global GDP by 7%Goldman Sachs, Joseph Briggs (5/4/23)
- The macroeconomic impact of artificial intelligence
PwC, Jonathan Gillham, Lucy Rimmington, Hugh Dance, Gerard Verweij, Anand Rao, Kate Barnard Roberts and Mark Paich (February 2018)
- How genAI is revolutionizing the field of economics
CNN, Bryan Mena and Samantha Delouya (12/10/23)
- AI-powered digital colleagues are here. Some ‘safe’ jobs could be vulnerable.
BBC Worklife, Sam Becker (30/11/23)
- Generative AI and Its Economic Impact: What You Need to Know
Investopedia, Jim Probasco (1/12/23)
- AI is coming for our jobs! Could universal basic income be the solution?
The Guardian Philippa Kelly (16/11/23)
- CFPB chief’s warning: AI is a ‘natural oligopoly’ in the making
Politico, Sam Sutton (21/11/23)
Questions
- Which industries are most likely to benefit from the development of AI?
- Distinguish between labour-replacing and labour-augmenting technological progress in the context of AI.
- How could AI reduce the amount of labour per unit of output and yet result in an increase in employment?
- What people are most likely to (a) gain, (b) lose from the increasing use of AI?
- Is the distribution of income likely to become more equal or less equal with the development and adoption of AI? Explain.
- What policies could governments adopt to spread the gains from AI more equally?
We have examined inflation in several blogs in recent months. With inflation at levels not seen for 40 years, this is hardly surprising. One question we’ve examined is whether the policy response has been correct. For example, in July, we asked whether the Bank of England had raised interest rates too much, too late. In judging policy, one useful distinction is between demand-pull inflation and cost-push inflation. Do they require the same policy response? Is raising interest rates to get inflation down to the target rate equally applicable to inflation caused by excessive demand and inflation caused by rising costs, where those rising costs are not caused by rising demand?
In terms of aggregate demand and supply, demand-pull inflation is shown by continuing rightward shifts in aggregate demand (AD); cost-push inflation is shown by continuing leftward/upward shifts in short-run aggregate supply (SRAS). This is illustrated in the following diagram, which shows a single shift in aggregate demand or short-run aggregate supply. For inflation to continue, rather than being a single rise in prices, the curves must continue to shift.
As you can see, the effects on real GDP (Y) are quite different. A rise in aggregate demand will tend to increase GDP (as long as capacity constraints allow). A rise in costs, and hence an upward shift in short-run aggregate supply, will lead to a fall in GDP as firms cut output in the face of rising costs and as consumers consume less as the cost of living rises.
The inflation experienced by the UK and other countries in recent months has been largely of the cost-push variety. Causes include: supply-chain bottlenecks as economies opened up after COVID-19; the war in Ukraine and its effects on oil and gas supplies and various grains; and avian flu and poor harvests from droughts and floods associated with global warming resulting in a fall in food supplies. These all led to a rise in prices. In the UK’s case, this was compounded by Brexit, which added to firms’ administrative costs and, according to the Bank of England, was estimated to cause a long-term fall in productivity of around 3 to 4 per cent.
The rise in costs had the effect of shifting short-run aggregate supply upwards to the left. As well as leading to a rise in prices and a cost-of-living squeeze, the rising costs dampened expenditure.
This was compounded by a tightening of fiscal policy as governments attempted to tackle public-sector deficits and debt, which had soared with the support measures during the pandemic. It was also compounded by rising interest rates as central banks attempted to bring inflation back to target.
Monetary policy response
Central banks are generally charged with keeping inflation in the medium term at a target rate set by the government or the central bank itself. For most developed countries, this is 2% (see table in the blog, Should central bank targets be changed?). So is raising interest rates the correct policy response to cost-push inflation?
One argument is that monetary policy is inappropriate in the face of supply shocks. The supply shocks themselves have the effect of dampening demand. Raising interest rates will compound this effect, resulting in lower growth or even a recession. If the supply shocks are temporary, such as supply-chain disruptions caused by lockdowns during the pandemic, then it might be better to ride out the problem and not raise interest rates or raise them by only a small amount. Already cost pressures are easing in some areas as supplies have risen.
If, however, the fall in aggregate supply is more persistent, such as from climate-related declines in harvests or the Ukraine war dragging on, or new disruptions to supply associated with the Israel–Gaza war, or, in the UK’s case, with Brexit, then real aggregate demand may need to be reduced in order to match the lower aggregate supply. Or, at the very least, the growth in aggregate demand may need to be slowed to match the slower growth in aggregate supply.
Huw Pill, the Chief Economist at the Bank of England, in a podcast from the Columbia Law School (see links below), argued that people should recognise that the rise in costs has made them poorer. If they respond to the rising costs by seeking higher wages, or in the case of businesses, by putting up prices, this will simply stoke inflation. In these circumstances, raising interest rates to cool aggregate demand may reduce people’s ability to gain higher wages or put up prices.
Another argument for raising interest rates in the face of cost-push inflation is when those cost increases are felt more than in other countries. The USA has suffered less from cost pressures than the UK. On the other hand, its growth rate is higher, suggesting that its inflation, albeit lower than in the UK, is more of the demand-pull variety. Despite its inflation rate being lower than in the UK, the problem of excess demand has led the Fed to adopt an aggressive interest rate policy. Its target rate is 5.25% to 5.50%, while the Bank of England’s is 5.25%. In order to prevent short-term capital outflows and a resulting depreciation in the pound, further stoking inflation, the Bank of England has been under pressure to mirror interest rate rises in the USA, the eurozone and elsewhere.
Articles
Blogs on this site
Information and data
Questions
- How may monetary policy affect inflationary expectations?
- If cost-push inflation makes people generally poorer, what role does the government have in making the distribution of a cut in real income a fair one?
- In the context of cost-push inflation, how might the authorities prevent a wage–price spiral?
- With reference to the second article above, explain the ‘monetary policy conundrum’ faced by the Bank of Japan.
- If central banks have a single policy instrument, namely changes in interest rates, how may conflicts arise when there is more than one macroeconomic objective?
- Is Russia’s rise in inflation the result of cost or demand pressures, or a mixture of the two (see articles above)?
China has been an economic powerhouse in recent decades – a powerhouse that has helped to drive the world economy through trade and both inward and outward investment. At the same time, its low-priced exports have helped to dampen world inflation. But is all this changing? Is China, to use President Biden’s words, a ‘ticking time bomb’?
China’s economic growth rate is slowing, with the quarterly growth in GDP falling from 2.2% in Q1 this year to 0.8% in Q2. Even though public-sector investment rose by 8.1% in the first six months of this year, private-sector investment fell by 0.2%, reflecting waning business confidence. And manufacturing output declined in August. But, despite slowing growth, the Chinese government is unlikely to use expansionary fiscal policy because of worries about growing public-sector debt.
The property market
One of the biggest worries for the Chinese economy is the property market. The annual rate of property investment fell by 20.6% in June this year and new home prices fell by 0.2% in July (compared with June). The annual rate of price increase for new homes was negative throughout 2022, being as low as minus 1.6% in November 2022; it was minus 0.1% in the year to July 2023, putting new-home prices at 2.4% below their August 2021 level. However, these are official statistics. According to the Japan Times article linked below, which reports Bloomberg evidence, property agents and private data providers report much bigger falls, with existing home prices falling by at least 15% in many cities.
Falling home prices have made home-owners poorer and this wealth effect acts as a brake on spending. The result is that, unlike in many Western countries, there has been no post-pandemic bounce back in spending. There has also been a dampening effect on local authority spending. During the property boom they financed a proportion of their spending by selling land to property developers. That source of revenue has now largely dried up. And as public-sector revenues have been constrained, so this has constrained infrastructure spending – a major source of growth in China.
The government, however, has been unwilling to compensate for this by encouraging private investment and has tightened regulation of the financial sector. The result has been a decline in new jobs and a rise in unemployment, especially among graduates, where new white collar jobs in urban areas are declining. According to the BBC News article linked below, “In July, figures showed a record 21.3% of jobseekers between the ages of 16 and 25 were out of work”.
Deflation
The fall in demand has caused consumer prices to fall. In the year to July 2023, they fell by 0.3%. Even though core inflation is still positive (0.8%), the likelihood of price reductions in the near future discourages spending as people hold back, waiting for prices to fall further. This further dampens the economy. This is a problem that was experienced in Japan over many years.
Despite slowing economic growth, Chinese annual growth in GDP for 2023 is still expected to be around 4.5% – much lower than the average rate for 9.5% from 1991 to 2019, but considerably higher than the average of 1.1% forecast for 2023 for the G7 countries. Nevertheless, China’s exports fell by 14.5% in the year to July 2023 and imports fell by 12.5%. The fall in imports represents a fall in exports to China from the rest of the world and hence a fall in injections to the rest-of-the-world economy. Currently China’s role as a powerhouse of the world has gone into reverse.
Articles
Questions
- Using PowerPoint or Excel, plot the growth rate of Chinese real GDP, real exports and real imports from 1990 to 2024 (using forecasts for 2023 and 2024). Use data from the IMF’s World Economic Outlook database. Comment on the figures.
- Explain the wealth effect from falling home prices.
- Why may official figures understate the magnitude of home price deflation?
- Explain the foreign trade multiplier and its relevance to other countries when the volume of Chinese imports changes. What determines the size of this multiplier for a specific country?
- How does the nature of the political system in China affect the likely policy response to the problems identified in this blog?
- Is there any good news for the rest of the world from the slowdown in the Chinese economy?