Category: Essentials of Economics 9e

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Looming stagflation


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.

Articles

Reports etc.

Questions

  1. What are the most efficient policies for helping those in energy poverty?
  2. Why is inflation forecast to fall later in 2023?
  3. What determines the shape of the short-run aggregate supply curve?
  4. What government policies would support (a) labour productivity; (b) investment?
  5. How might the market solve the problem of supply shortages?
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A confluence of calamities

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

  1. Draw an aggregate demand and supply diagram (AD/AS or DAD/DAS) to illustrate the effect of a supply shock on output and prices.
  2. Give some examples of supply-side policies that could help in the current situation.
  3. What are the arguments for and against countries using protectionist policies at the current time?
  4. 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?
  5. What are the arguments for and against imposing a windfall tax on energy companies and using the money to support poor people?
  6. If the world slips into recession, should central banks and governments use expansionary monetary and fiscal policies?
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Tackling the menace of fly-tipping

If it costs to dispose of waste, there is the danger that people may resort to fly-tipping – the illegal dumping of waste in the countryside or on the streets. But several local authorities have indeed been charging for the disposal of building/DIY waste, with the inevitable consequences of huge quantities of dumped rubbish.

Apart from being an eyesore and damaging the environment, fly-tipped waste can be a health hazard, often containing toxic materials, such as asbestos and chemicals. According to the UK government, in 2020/21 there were over 60 000 incidents of fly-tipping of construction, demolition and excavation material, costing an estimated £392 million. In addition, people leave black bags of household waste and single items, such as mattresses, on the roadside.

The external costs are considerably greater than the benefits to those doing the dumping, but because the costs are largely external, people are encouraged to fly-tip, especially if they think that they are unlikely to be caught. Many householders are happy to pay low rates to have their DIY waste disposed of and ‘ask no questions’ about what will happen to it.

It is clearly socially efficient to stop fly-tipping. One solution is to enforce the law more rigorously and to introduce stiffer penalties. Increasingly, local authorities and private landowners are installing CCTV cameras to identify people doing the tipping. To be effective, the cameras must be out of reach. Also, the police must then follow up any cases and arrest and charge the culprits.

An alternative is to provide free disposal at council tips. The UK government has launched a consultation on a proposal to prevent local authorities from charging for the disposal of DIY waste. This still involves an externality in that the costs of disposal are not being borne by the person creating the waste, but clearly the size of the negative externality is considerably less than if the waste had been fly-tipped.

Selected local authorities can apply for new grants totalling £450 000 to help fund the provision of free DIY waste disposal and to install systems, such as CCTV and automatic number-plate recognition, to catch fly-tippers in action.

Devising policies to reduce externalities often involves understanding the incentive mechanisms which encourage people to engage in such activities in the first place and then making it in people’s interests not to engage in them in the future.

Videos

Articles

Government publications

Questions

  1. Draw a diagram to illustrate how the consumption of products with large negative externalities is considerably above the socially efficient level.
  2. Compare the relative advantages and disadvantages of the various policy alternatives to tackle fly-tipping that are discussed in the articles.
  3. Are there any ‘nudges’ that could be used to prevent fly-tipping?
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A Spring dose of fiscal policy

On March 23, Rishi Sunak, the UK’s Chancellor of the Exchequer, delivered his Spring Statement, in which he announced changes to various taxes and grants. These measures were made against the background of rising inflation and falling living standards.

CPI inflation, currently at 6.2%, is still rising and the Office for Budget Responsibility forecasts that inflation will average 7.4% this year. The poor spend a larger proportion of their income on energy and food than the rich. With inflation rates especially high for gas, electricity and basic foodstuffs, the poor have been seen their cost of living rise by considerably more than the overall inflation rate.

According to the OBR, the higher inflation, by reducing real income and consumption, is expected to reduce the growth in real GDP this year from the previously forecast 6% to 3.8% – a much smaller bounce back from the fall in output during the early stages of the pandemic. Despite this growth in GDP, real disposable incomes will fall by an average of £488 per person this year. As the OBR states:

With inflation outpacing growth in nominal earnings and net taxes due to rise in April, real living standards are set to fall by 2.2 per cent in 2022/23 – their largest financial year fall on record – and not recover their pre-pandemic level until 2024/25.

Fiscal measures

The Chancellor announced a number of measures, which, he argued, would provide relief from rises in the cost of living.

  • Previously, the Chancellor had announced that national insurance (NI) would rise by 1.25 percentage points this April. In the Statement he announced that the starting point for paying NI would rise from a previously planned £9880 to £12 570 (the same as the starting point for income tax). This will more than offset the rise in the NI rate for those earning below £32 000. This makes the NI system slightly more progressive than before. (Click here for a PowerPoint of the chart.)
  • A cut in fuel duty of 5p per litre. The main beneficiaries will be those who drive more and those with bigger cars – generally the better off. Those who cannot afford a car will not benefit at all, other than from lower transport costs being passed on in lower prices.
  • The 5% VAT on energy-saving household measures such as solar panels, insulation and heat pumps will be reduced to zero.
  • The government’s Household Support Fund will be doubled to £1bn. This provides money to local authorities to help vulnerable households with rising living costs.
  • Research and development tax credits for businesses will increase and small businesses will each get another £1000 per year in the form of employment allowances, which reduce their NI payments. He announced that taxes on business investment will be further cut in the Autumn Budget.
  • The main rate of income tax will be cut from 20% to 19% in two years’ time. Unlike the rise in NI, which only affects employment and self-employment income, the cut in income tax will apply to all incomes, including rental and savings income.

Fiscal drag

The Chancellor announced that public finances are stronger than previously forecast. The rapid growth in tax receipts has reduced public-sector borrowing from £322 billion (15.0 per cent of GDP) in 2020/21 to an expected £128 billion (5.4 per cent of GDP) in 2021/22, £55 billion less than the OBR forecast in October 2021. This reflects not only the growth in the economy, but also inflation, which results in fiscal drag.

Fiscal drag is where rises in nominal incomes mean that the average rate of income tax rises. As tax thresholds for 2022/23 are frozen at 2021/22 levels, a greater proportion of incomes will be taxed at higher rates and tax-free allowances will account for a smaller proportion of incomes. The higher the rate of increase in nominal incomes, the greater fiscal drag becomes. The higher average rate of tax drags on real incomes and spending. On the other hand, the extra tax revenue reduces government borrowing and gives the government more room for extra spending or tax cuts.

The growth in poverty

With incomes of the poor not keeping pace with inflation, many people are facing real hardship. While the Spring Statement will provide a small degree of support to the poor through cuts in fuel duty and the rise in the NI threshold, the measures are poorly targeted. Rather than cutting fuel duty by 5p, a move that is regressive, removing or reducing the 5% VAT on gas and electricity would have been a progressive move.

Benefits, such as Universal Credit and the State Pension, are uprated each April in line with inflation the previous September. When inflation is rising, this means that benefits will go up by less than the current rate of inflation. This April, benefits will rise by last September’s annual inflation rate of 3.1% – considerably below the current inflation rate of 6.2% and the forecast rate for this year of 7.4%. This will push many benefit recipients deeper into poverty.

One measure rejected by Rishi Sunak is to impose a temporary windfall tax on oil companies, which have profited from the higher global oil prices. Such taxes are used in Norway and are currently being considered by the EU. Tax revenues from such a windfall tax could be used to fund benefit increases or tax reductions elsewhere and these measures could be targeted on the poor.

Articles

OBR data and analysis

Questions

  1. Are the changes made to national insurance by the Chancellor progressive or regressive? Could they have been made more progressive and, if so, how?
  2. What are the arguments for and against cutting income tax from 20% to 19% in two years’ time rather than reversing the current increases in national insurance at that point?
  3. What will determine how rapidly (if at all) public-sector borrowing decreases over the next few years?
  4. What are automatic fiscal stabilisers? How does their effect vary with the rate of inflation?
  5. Examine the public finances of another country. Are the issues similar to those in the UK? Recommend fiscal policy measures for your chosen country and provide a justification.
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The surging price of oil: a question of supply and demand

Global oil prices (Brent crude) reached $128 per barrel on 9 March, a level not seen for 10 years and surpassed only in the run up to the financial crisis in 2008. Oil prices are determined by global demand and supply, and the current surge in prices is no exception.

A rise in demand and/or a fall in supply will lead to a rise in the price. Given that both demand and supply are relatively price inelastic, such shifts can cause large rises in oil prices. Similarly, a fall in demand or rise in supply can lead to a large fall in oil prices.

These changes are then amplified by speculation. Traders try to get ahead of price changes. If people anticipate that oil prices will rise, they will buy now, or make a contract to buy more in the future at prices quoted today by buying on the oil futures market. This then pushes up both spot (current) prices and futures prices. If demand or supply conditions change, speculation will amplify the reaction to such a change.

What has happened since 2019?

In 2019, oil was typically trading at around $60 to $70 per barrel. It then fell dramatically in early 2020 as the onset of COVID-19 led to a collapse in demand, for both transport and industry. The price fell below $20 in late April (see charts: click here for a PowerPoint).

Oil prices then rose rapidly as demand recovered somewhat but supply chains, especially shipping, were suffering disruptions. By mid-2021, oil was once more trading at around $60 to $70 per barrel. But then demand grew more strongly as economic recovery from COVID accelerated. But supply could not grow so quickly. By January 2022, Brent crude had risen above $80 per barrel.

Then worries began to grow about Russian intentions over Ukraine as Russia embarked on large-scale military exercises close to the border with Ukraine. People increasingly disbelieved Russia’s declarations that it had no intention to invade. Russia is the world’s second biggest producer of oil and people feared that deliberate disruptions to supply by Russia or other countries banning imports of Russian oil would cause supply shortages. Speculation thus drove up the oil price. By 23 February, the day before the Russian invasion of Ukraine, Brent crude had risen to $95.

With the Russian invasion, moves were made by the EU the USA and other countries to ban or limit the purchase of Russian oil. This increased the demand for non-Russian oil.

On 8 March, the USA announced that it was banning the import of Russian oil with immediate effect. The same day, the UK announced that it would phase out the import of Russian oil and oil products by the end of 2022.

The EU is much more dependent on Russian oil imports, which account for around 27% of EU oil consumption and 2/3 of extra-EU oil imports. Nevertheless, it announced that it would accelerate the move away from Russian oil and gas and towards green alternatives. By 8 March, Brent crude had risen to $128 per barrel.

The question was then whether other sources of supply would help to fill the gap. Initially it seemed that OPEC+ (excluding Russia) would not increase production beyond the quotas previously agreed by the cartel to meet recovery in world demand. But then, on 9 March, the UAE Ambassador to Washington announced that the county favoured production increases and would encourage other OPEC members to follow suit. With the announcement, the oil price fell by 11% to £111. But the next day, it rose again somewhat as the UAE seemed to backtrack, but then fell back slightly as OPEC said there was no shortage of oil.

This is obviously an unfolding story with the suffering of the Ukrainian people at its heart. But the concepts of supply and demand and their price elasticity and the role of speculation are central to understanding what will happen to oil prices in the coming months with all the consequences for poverty and economic hardship.

Articles

Data

Questions

  1. Use a demand and supply diagram to illustrate what has happened to oil prices over the past two years. How has the size of the effects been dependent on the price elasticity of demand for oil and the price elasticity of supply of oil?
  2. Use a demand and supply diagram to show what has been happening to the price of natural gas over the past two years. Are the determinants similar to those in the oil market? How do they differ (if at all)?
  3. What policy options are open to governments to deal with soaring energy prices?
  4. What are the distributional consequences of the rise in energy prices? (see the blog: Rise in the cost of living.)
  5. Under what circumstances are oil prices over the next six months likely (a) fall; (b) continue rising?