Both business and consumer confidence are affected by the state of the economy. A recession, or even a slowdown in the economy, will make people worried for their jobs and future incomes and hence cut back on spending and either save more or reduce their debts. Similarly firms are likely to cut back on investment if they are pessimistic about the future. But both consumer demand and investment are components of aggregate demand. A cut in aggregate demand will drive the economy further into recession and cause even greater pessimism. In other words, there is a feedback loop. Recession causes pessimism and hence a fall in aggregate demand, which, in turn, worsens the recession.
A similar process of feedback occurs in times of optimism. If the economy recovers, or is thought to be about to do so, the resulting optimism will cause people and firms to spend more. This rise in aggregate demand will help the process of recovery (see Accelerating the recession and Animal Spirits).
The following article by Robert Shiller, co-author of Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, looks at the swing from pessimism to optimism over the past few months.
An Echo Chamber of Boom and Bust: Robert Schiller New York Times (29/8/09)
Efficient Market Hypothesis: True “Villain” of the Financial Crisis? The Market Oracle (26/8/09)
Monthly confidence indicators for the EU can be found at:
Business and Consumer Surveys: Time Series European Commission Directorate-General for Economic and Financial Affairs. (Each of the ‘en’ cells links to a zipped Excel file.)
Questions
- Explain why “confidence has rebounded so quickly in so many places” in recent weeks.
- Is Robert Shiller’s explanation of feedback loops consistent with the accelerator theory?
- In what circumstances do business and consumer psychology result in destabilising speculation and what causes turning points in the process? Why may such turning points be difficult to predict?
- Examine the monthly Economic Sentiment Indicator (ESI) for the UK from the ‘Business and Consumer Surveys: Time Series’ link above. You will need to refer to the final column in the Excel ESI Monthly worksheet (Column GV). Chart the movements in this indicator over the past three years. Also chart the quarterly growth in UK GDP over the same time period. You can find data from Economic and Labour Market Review (ONS), Data tables, Table 1.01, Column YBEZ. Is ESI a leading or a lagging indicator of GDP?
- What implications does Shiller’s analysis have for the management of the economy?
- Why may stock market movements not be a ‘random walk’?
The following articles look at a recently published book by George Akerlof of the University of California, Berkeley, and Robert Shiller of Yale. They examine the role of what Keynes called ‘animal spirits’ and is the title of the book.
The motivation to make economic decisions (to buy, to sell, to invest, etc) may not be ‘rational’ in the sense of carefully weighing up marginal costs and marginal benefits. Rather it can be one of over-optimism in good times or over-pessimism in bad times. Just as individuals have ‘mood swings’, so there can be collective mood swings too. After all, confidence, or lack of it, is contagious. This motivation that drives people to action is what is meant by animal spirits.
But are animal spirits a blessing to be nurtured or a curse to be reined in? Should governments seek to constrain them?
An economic bestiary The Economist (26/3/09)
Good Government and Animal Spirits Wall Street Journal (23/4/09)
Irrational Exuberance New York Times (17/4/09)
Animal Spirits: A Q&A With George Akerlof Freakonomics: New York Times blog (30/4/09)
Questions
- Describe what is meant by ‘animal spirits’ and their effects on human behaviour.
- Why may animal spirits make economies less stable?
- How may animal spirits help to explain exchange rate overshooting?
- Discuss whether governments should seek to constrain animal spirits and make people more ‘rational’? Also consider what methods governments could/should use to do this?
One of the industries always hard hit by any economic downturn is the building and construction industry. The three articles below look at different aspects of the construction downturn. The building industry in Spain (article 1) has been particularly hard hit, perhaps because of the previous scale of the boom. When there is a recession, different industries are always hit in different ways, depending on the nature of the demand they face. Construction and building can be very badly affected as much of the expenditure on them is ‘investment’ expenditure and this will often be delayed in times of economic downturn.
Building boom reduced to ruins by collapse of Spain’s economic miracle Guardian (19/1/09)
Housing starts lowest since 1924 as construction bears brunt of recession Guardian (15/12/08)
UK construction activity slumps to record low Times Online (5/1/09)
Questions
- Write a short paragraph explaining the current state of the construction industry in the UK.
- Explain the accelerator theory.
- Discuss the extent to which the accelerator theory might help to explain the current state of the construction industry in the UK and Spain.
Inflationary expectations can be an important determinant of the actual level of inflation and so the Bank of England monitor people’s perceptions of inflation closely. Expectations of inflation are currently at their highest level in eight years.
Questions
| 1. |
Explain the transmission mechanism by which higher inflationary expectations are translated into inflation. |
| 2. |
What are the key determinants of inflationary expectations? |
| 3. |
Discuss strategies that (a) the Bank of England and (b) the government can adopt to reduce inflationary expectations. |
As part of its Target 2.0 competition for students, The Times published a series of briefings looking at the factors that cause inflation. The one linked below considers the role of labour markets in determining inflation.
Interplay of work and inflation rate Times Online (2/2/07)
Questions
| 1. |
Explain the key determinants of the equilibrium level of wages in the labour market. |
| 2. |
Assess the role of equilibrium labour market wages in the determination of the level of inflation. |
| 3. |
Discuss the extent to which the NAIRU is still a relevant theory when considering the determinants of inflation. |