Tag: aggregate demand

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A Keynesian route to recovery in output and employment?

Boris Johnson gave a speech on 30 June outlining his government’s approach to recovery from the sharpest recession on record. With the slogan ‘Build, build, build’, he said that infrastructure projects were the key to stimulating the economy. Infrastructure spending is a classic Keynesian response to recession as it stimulates aggregate demand allowing slack to be taken up, while also boosting aggregate supply, thereby allowing recovery in output while increasing potential national income.

A new ‘New deal’

He likened his approach to that of President Franklin D Roosevelt’s New Deal. This was a huge stimulus between 1933 and 1939 in an attempt to lift the US economy out of the Great Depression. There was a massive programme of government spending on construction projects, such as hospitals, schools, roads, bridges and dams, including the Hoover Dam and completing the 113-mile Overseas Highway connecting mainland Florida to the Florida Keys. Altogether, there were 34 599 projects, many large-scale. In addition, support was provided for people on low incomes, the unemployed, the elderly and farmers. Money supply was expanded, made possible by leaving the Gold Standard in 1934.

There was some debate as to whether the New Deal could be classed as ‘Keynesian’. Officially, the administration was concerned to achieve a balanced budget. However, it had a separate ’emergency budget’, from which New Deal spending was financed. According to estimates by the Federal Reserve Bank of St Louis, the total extra spending amounted to nearly 40% of US GDP as it was in 1929.

By comparison with the New Deal, the proposals of the Johnson government are extremely modest. Mostly it amounts to bringing forward spending already committed. The total of £5 billion is just 0.2% of current UK GDP.

Focusing on jobs

A recent report published by the Resolution Foundation, titled ‘The Full Monty‘, argues that as the Job Retention Scheme, under which people have been furloughed on 80% pay, is withdrawn, so unemployment is set to rise dramatically. The claimant count has already risen from 1.2m to 2.8m between March and May with the furlough scheme in place.

Policy should thus focus on job creation, especially in those sectors likely to experience the largest rise in unemployment. Such sectors include non-food retail, hospitality (pubs, restaurants, hotels, etc.), public transport, the arts, entertainment and leisure and a range of industries servicing these sectors. What is more, many of the people working in these sectors are young and low paid. Many will find it difficult to move to jobs elsewhere – partly because of a lack of qualifications and partly because of a lack of alternative jobs. The rising unemployment will raise inequality.

The Resolution Foundation report argues that policy should be focused specifically on job creation.

Policy makers should act now to minimise outflows from the hard-hit sectors – a wage subsidy scheme or a National Insurance cut in those sectors would reduce labour costs and discourage redundancies. Alongside this, the Government must pursue radical action to create jobs across the country, such as in social care and housing retrofitting, and ramp up support for the unemployed.

Dealing with hyteresis

The economy is set to recover somewhat as the lockdown is eased, but it is not expected to return to the situation before the pandemic. Many jobs will be lost permanently unless government support continues.

Even then, many firms will have closed and others will have reassessed how many workers they need to employ and whether less labour-intensive methods would be more profitable. They may take the opportunity to consider whether technology, such as AI, can replace labour; or they may prefer to employ cheap telecommuters from India or the Philippines rather than workers coming into the office.

Policies to stimulate recovery will need to take these hysteresis effects into account if unemployment is to fall back to pre-Covid rates.

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Questions

  1. What are the arguments for and against substantial increased government expenditure on infrastructure projects?
  2. Should the UK government spend more or less on such projects than the amount already pledged? Justify your answer.
  3. What are the arguments for and against directing all extra government expenditure towards green projects?
  4. Look through the Resolution Foundation report and summarise the findings of each of its sections.
  5. What are the arguments for and against directing all extra government expenditure towards those sectors where there is the highest rate of job losses?
  6. What form could policies to protect employment take?
  7. How should the success of policies to generate employment be measured?
  8. What form does hysteresis play on the post-Covid-19 labour market? What four shocks mean that employment will not simply return to the pre-Covid situation?
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A global supply-side shock: the impact of the coronavirus (COVID-19) outbreak

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

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

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

Economic uncertainty

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

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

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

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

Longer-term effects

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

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

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

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Questions

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

The Institute of Fiscal Studies (IFS) has just published its annual ‘Green Budget‘. This is, in effect, a pre-Budget report (or a substitute for a government ‘Green Paper’) and is published ahead of the government’s actual Budget.

The Green Budget examines the state of the UK economy, likely economic developments and the implications for macroeconomic policy. This latest Green Budget is written in the context of Brexit and the growing likelihood of a hard Brexit (i.e. a no-deal Brexit). It argues that the outlook for the public finances has deteriorated substantially and that the economy is facing recession if the UK leaves the EU without a deal.

It predicts that:

Government borrowing is set to be over £50 billion next year (2.3% of national income), more than double what the OBR forecast in March. This results mainly from a combination of spending increases, a (welcome) change in the accounting treatment of student loans, a correction to corporation tax revenues and a weakening economy. Borrowing of this level would breach the 2% of national income ceiling imposed by the government’s own fiscal mandate, with which the Chancellor has said he is complying.

A no-deal Brexit would worsen this scenario. The IFS predicts that annual government borrowing would approach £100 billion or 4% of GDP. National debt (public-sector debt) would rise to around 90% of GDP, the highest for over 50 years. This would leave very little scope for the use of fiscal policy to combat the likely recession.

The Chancellor, Sajid Javid, pledged to increase public spending by £13.4bn for 2020/21 in September’s Spending Review. This was to meet the Prime Minister’s pledges on increased spending on police and schools. This should go some way to offset the dampening effect on aggregate demand of a no-deal Brexit. The government has also stated that it wishes to cut various taxes, such as increasing the threshold at which people start paying the 40% rate of income tax from £50 000 to £80 000. But even with a ‘substantial’ fiscal boost, the IFS expects little or no growth for the two years following Brexit.

But can fiscal policy be used over the longer term to offset the downward shock of Brexit, and especially a no-deal Brexit? The problem is that, if the government wishes to prevent government borrowing from soaring, it would then have to start reining in public spending again. Another period of austerity would be likely.

There are many uncertainties in the IFS predictions. The nature of Brexit is the obvious one: deal, no deal, a referendum and a remain outcome – these are all possibilities. But other major uncertainties include business and consumer sentiment. They also include the state of the global economy, which may see a decline in growth if trade wars increase or if monetary easing is ineffective (see the blog: Is looser monetary policy enough to stave off global recession?).

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Questions

  1. Why would a hard Brexit reduce UK economic growth?
  2. To what extent can expansionary fiscal policy stave off the effects of a hard Brexit?
  3. Does it matter if national debt (public-sector debt) rises to 90% or even 100% of GDP? Explain.
  4. Find out the levels of national debt as a percentage of GDP of the G7 countries. How has Japan managed to sustain such a high national debt as a percentage of GDP?
  5. How can an expansionary monetary policy make it easier to finance the public-sector debt?
  6. How has investment in the UK been affected by the Brexit vote in 2016? Explain.
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Is looser monetary policy enough to stave off global recession?

With the prospects of weaker global economic growth and continuing worries about trade wars, central banks have been loosening monetary policy. The US central bank, the Federal Reserve, lowered its target Federal Funds rate in both July and September. Each time it reduced the rate by a quarter of a percentage point, so that it now stands at between 1.75% and 2%.

The ECB has also cut rates. In September it reduced the overnight deposit rate for banks from –0.4% to –0.5%, leaving the main rate at 0%. It also introduced a further round of quantitative easing, with asset purchases of €20 billion per month from 1 November and lasting until the ECB starts raising interest rates.

The Australian Reserve Bank has cut its ‘cash rate‘ three times this year and it now stands at an historically low level of 0.75%. Analysts are predicting that it may be forced to introduce quantitative easing if lower interest rates fail to stimulate growth.

Japan continues with its programme of quantitative easing (QE) and other central banks are considering lowering interest rates and/or (further) QE.

But there are two key issues with looser monetary policy.

The first is whether it will be sufficient to provide the desired stimulus. With interest rates already at or near historic lows (although slightly above in the case of the USA), there is little scope for further reductions. QE may help, but without a rise in confidence, the main effect of the extra money may simply be a rise in the price of assets, such as property and shares. It may result in very little extra spending on consumption and investment – in other words, very little extra aggregate demand.

The second is the effect on inequality. By inflating asset prices, QE rewards asset owners. The wealthier people are, the more they will gain.

Many economists and commentators are thus calling for the looser monetary policy to be backed up by expansionary fiscal policy. The boost to aggregate demand, they argue, should come from higher public spending, with governments able to borrow at very low interest rates because of the loose monetary policy. Targeted spending on infrastructure would have a supply-side benefit as well as a demand-side one.

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ECB Press Conference

Questions

  1. Explain what is meant by quantitative easing.
  2. What determines the effectiveness of quantitative easing?
  3. Why is President Trump keen for the Federal Reserve to pursue more aggressive interest rate cuts?
  4. What is the Bank of England’s current attitude towards changing interest rates and/or further quantitative easing?
  5. What are the current advantages and disadvantages of governments pursuing a more expansionary fiscal policy?
  6. Compare the relative merits of quantitative easing through asset purchases and the use of ‘helicopter money’.
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A moral hazard in cancelling student debt?

With university fees for home students in England of £9250 per year and with many students receiving maintenance loans of around £9000 per year, many students are graduating with debts in excess of £50 000. Loans are repaid at a marginal rate of 9% on incomes over £25 716.

Many students also study for a masters degree. The average fee for a taught, classroom-based masters (MA) is £7392 and for a laboratory-based masters (MSc) is £8167 but can be considerably higher at some prestigious universities where demand is high. Government loans of up to £10 906 are available to contribute towards fees and maintenance. These are paid back at a marginal rate of 6% for people earning over £21 000, giving a combined marginal rate of 15% for first and masters degrees.

For high earners on the 40% income tax rate, the combined marginal rate of payment out of income is 40% tax, plus 2% national insurance, plus 15% for those with undergraduate and masters loans. This gives a combined marginal rate of 57%.

Average student debt in England is higher even than in the USA, where the average is $37 000. US university courses are more expensive than in the UK, costing an average of $34 000 per year in tuition alone. But undergraduates can borrow less. They can borrow between $5500 and $12 500 per year in federal loans towards both fees and maintenance, and some private loans are also available. Most students do some paid work during their studies to make up the difference or rely on parents contributing. Parental contributions mean that students from poor families end up owing more. According to a Guardian article:

Race is a huge factor. Black students owe an average of $7400 more than white students when they graduate, the Brookings Institution found. After graduation, the debt gap continues to widen. Four years after graduation, black graduates owe an average of nearly $53 000 – nearly double that of white graduates.

Student debt looks to become one of the key issues in the 2020 US presidential election.

Pressure to cancel student fees and debt in the USA

Most of the Democratic candidates are promising to address student fees and debt. Student debt, they claim, places an unfair burden on the younger generation and makes it hard for people to buy a house, or car or other major consumer durables. This also has a dampening effect on aggregate demand.

The most radical proposal comes from Bernie Sanders. He has vowed, if elected, to abolish student fees and to cancel all undergraduate and graduate debt of all Americans. Other candidates are promising to cut fees and/or debt.

Although most politicians and commentators agree that the USA has a serious problem of student debt, there is little agreement on what, if anything, to do about it. There are already a number of ways in which student debt can be written off or reduced. For example, if you work in the public sector for more than 10 years, remaining debt will be cancelled. However, none of the existing schemes is as radical as that being proposed by many Democrats.

Criticisms of the Democrats’ plans are mainly of two types.

The first is the sheer cost. Overall debt is around $1.6tn. What is more, making student tuition free would place a huge ongoing burden on government finances. Bernie Sanders proposes introducing a financial transactions tax on stock trading. This would be similar to a Tobin tax (sometimes dubbed a ‘Robin Hood tax’) and would include a 0.5% tax on stock transactions, a 0.1% tax on bond trades and a 0.005% tax on transactions in derivatives. He argues that the public bailed out the financial sector in 2008 and that it is now the turn of the financial sector to come to the aid of students and graduates.

The other type of criticism concerns the incentive effects of the proposal. The core of the criticism is that loan forgiveness involves moral hazard.

The moral hazard of loan forgiveness

The argument is that cancelling debt, or the promise to do so, encourages people to take on more debt. Generally, moral hazard occurs when people are protected from the consequences of their actions and are thus encouraged to make riskier decisions. For example, if you are ensured against theft, you may be less careful with your belongings. As the Orange County Register article linked below states:

If the taxpayers pay the debts of everyone with outstanding student loans, how will that affect the decisions made by current students thinking about their choices for financing higher education? What’s the message? Borrow as much as you can and wait for the debt to be canceled during the next presidential primary campaign?

Not only would more students be encouraged to go to college, but they would be encouraged to apply for more costly courses if they were free.

Universities would be encouraged to exaggerate their costs to warrant higher fees charged to the government. The government (federal, state or local) would have to be very careful in auditing courses to ensure costs were genuine. Universities could end up being squeezed for finance as government may try to cut payments by claiming that courses were overpriced.

Even if fees were not abolished, cancelling debts would encourage students to take on larger debt, if that was to be cleared at some point in the future. What is more, students (or their parents) who could afford to pay, would choose to borrow the money instead.

But many countries do have free or highly subsidised higher education. Universities are given grants which are designed to reflect fair costs.

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Questions

  1. Assess the arguments for abolishing or substantially reducing student fees.
  2. Assess the arguments against abolishing or substantially reducing student fees.
  3. Assess the arguments for writing off or substantially reducing student debt.
  4. Assess the arguments against writing off or substantially reducing student debt.
  5. If it were decided to cancel student debt, would it be fair to pay students back for any debt they had already paid off?
  6. Does tackling the problem of student debt necessarily lead to a redistribution of wealth/income?
  7. Give some other examples of moral hazard.
  8. If student fees were abolished, would there be any problem of adverse selection? If so, how could this be overcome?
  9. Find out what the main UK parties are advocating about student fees and debt in the nations of the UK for home and non-home students. Provide a critique of each of their policies.