The UK’s poor record on productivity since the 2008 financial crisis is well documented, not least in this blog series. Output per worker has flatlined over the 17 years since the crisis. As was noted in the blog, The UK’s poor productivity record, low UK productivity is caused by a number of factors, including the lack of investment in training, the poor motivation of many workers and the feeling of being overworked, short-termism among politicians and management, and generally poor management practices.
One of the most significant issues identified by analysts and commentators is the lack of investment in physical capital, both by private companies and by the government in infrastructure. Gross fixed capital formation (a measure of investment) has been much lower in the UK compared to international competitors.
From Figure 1 it can be observed that, since the mid-1990s, the UK has consistently had lower investment as a percentage of GDP compared to other significant developed market economies. The cumulative effect of this gap has contributed to lower productivity and lower economic growth.
Interestingly, since the financial crisis, UK firms have had high profitability and associated high cash holdings. This suggests that firms have had a lot of financial resources to reinvest. However, data from the OECD suggests that reinvestment rates in the UK, typically 40–50% of profit, are much lower than in many other OECD countries. In the USA the rate is 50%, in Germany 60–70% and in Japan 70%+. There is much greater emphasis in the UK on returning funds to shareholders through dividends and share buybacks. However, the reinvestment of much of this cash within firms could have gone some way to addressing the UK’s investment gap – but, it hasn’t been done.
Analysis by the OECD suggest that, while the cost of financing investment has declined since the financial crisis, the gap between this and the hurdle rate used to appraise investments has widened. Between 2010 and 2021 the difference nearly doubled to 4%. This increase in the hurdle rate can be related to increases in the expected rate of return by UK companies and their investors.
In this blog we will analyse (re)investment decisions by firms, discussing how increases in the expected rate of return in the UK raise the hurdle rate used to appraise investments. This reduces the incentive to engage in long-term investment. We also discuss policy prescriptions to improve reinvestment rates in the UK.
Investment and the expected rate of return
Investment involves the commitment of funds today to reap rewards in the future. This includes spending on tangible and intangible resources to improve the productive capacity of firms. Firms must decide whether the commitment of funds is worthwhile. To do so, economic theory suggests that they need to consider the compensation required by their provider of finance – namely, investors.
What rewards do investors require to keep their funds invested with the firm?
When conducting investment appraisal, firms compare the estimated rate of return from an investment with the minimum return investors are prepared to receive (termed the ‘expected return’). Normally this is expressed as a percentage of the initial outlay. Firms have to offer returns to investors which are equal to or greater than the minimum expected return – the return that is sufficient to keep funds invested in the firm. Therefore, returns above this minimum expected level are termed ‘excess returns’.
When firms conduct appraisals of potential investments, be it in tangible or intangible capital, they need to take into account the fact that net benefits, expressed as cash flows, will accrue over the life of the investment, not all at once. To do this, they use discounted cash flow (DCF) analysis. This converts future values of the net benefits to their present value. This is expressed as follows:
Where:
NPV = Net present value (discounted net cash flows);
K = Capital outlay (incurred at the present time);
C = Net cash flows (occur through the life of the investment project);
r = Minimum expected rate of return.
In this scenario, the investment involves an initial cash outlay (K), followed in subsequent periods by net cash inflows each period over the life of the investment, which in this case is 25 years. All the cash flows are discounted back to the present so that they can be compared at the same point in time.
The discount rate (r) used in appraisals to determine the present value of net cash flows is determined by the minimum expected return demanded by investors. If at that hurdle rate there are positive net cash flows (+NPV), the investment is worthwhile and should be pursued. Conversely, if at that hurdle rate there are negative net cash flows (–NPV), the investment is not worthwhile and should not be pursued.
According to economic theory, if a firm cannot find any investment projects that produce a positive NPV, and therefore satisfy the minimum expected return, it should return funds to shareholders through dividends or share buybacks so that they can invest the finance more productively.
Firm-level data from the OECD suggest that UK firms have had higher profits and this has been associated with increased cash holdings. But, due to the higher hurdle rate, less investment is perceived to be viable and thus firms distribute more of their profits through dividends and share buybacks. These payouts represent lost potential investment and cumulatively produce a significant dent in the potential output of the UK economy.
Why are expected rates of return higher in the UK?
This higher minimum rate of expected return can be explained by factors influencing its determinants; opportunity cost and risk/uncertainty.
Higher opportunity cost. Opportunity cost relates to the rate of return offered by alternatives. Investors and, by implication firms, will have to consider the rate of return offered by alternative investment opportunities. Typically, investors have focused on interest rates as a measure of opportunity cost. Higher interest rates raise the opportunity cost of an investment and increase the minimum expected rate of return (and vice versa with lower interest rates).
However, it is not interest rates that have increased the opportunity cost, and hence the minimum expected rate of return associated with investment, in the UK since the financial crisis. For most of the period since 2008, interest rates have been extremely low, sitting at below 1%, only rising significantly during the post-pandemic inflationary surge in 2022. This indicates that this source of opportunity cost for the commitment of business investment has been extremely low.
However, there may be alternative sources of opportunity cost which are pushing up the expected rate of return. UK investors are not restricted to investing in the UK and can move their funds between international markets determined by the rate of return offered. The following table illustrates the returns (in terms of percentage stock market index gain) from investing in a sample of UK, US, French and German stock markets between August 2010 and August 2025.
When expressed in sterling, returns offered by UK-listed companies are lower across the whole period and in most of the five-yearly sub-periods. Indeed, the annual equivalent rate of return (AER) for the FTSE 100 index across the whole period is less than half that of the S&P 500. The index offered a paltry annual return of 2.57% between 2015 and 2020, while the US index offered a return of 16.48%. Both the French and German indices offered higher rates of return, in the latter part of the period particularly. This represents a higher opportunity cost for UK investors and may have increased their expectations about the return they require for UK investments.
Greater perceived risk/uncertainty. Expected rates of return are also determined by perceptions of risk and uncertainty – the compensation investors need to bear the perceived risk associated with an investment. Investors are risk averse. They demand higher expected return as compensation for higher perceived risk. Higher levels of risk aversion increase the expected rate of return and related investment hurdle rates.
There has been much discussion of increased uncertainty and risk aversion among global investors and firms (see the blogs Rising global uncertainty and its effects, World Uncertainty Index, The Chancellor’s fiscal dilemma and Investment set to fall as business is baffled by Trump). The COVID-19 pandemic, inflation shocks, the war in Ukraine, events across the Middle East and the trade policies adopted by the USA in 2025 have combined to produce a very uncertain business environment.
While these have been relatively recent factors influencing world-wide business uncertainty, perceptions of risk and uncertainty concerning the UK economy seem to be longer established. To measure policy-related economic uncertainty in the UK, Baker, Bloom and Davis at www.PolicyUncertainty.com construct an index based on the content analysis of newspaper articles mentioning terms reflecting policy uncertainty.
Figure 2 illustrates the monthly index from 1998 to July 2025. The series is normalised to standard deviation 1 prior to 2011 and then summed across papers, by month. Then, the series is normalised to mean 100 prior to 2011.
Some of the notable spikes in uncertainty in the UK since 2008 have been labelled. Beginning with the global financial crisis, investors and firms became much more uncertain. This was exacerbated by a series of economic shocks that hit the economy, one of which, the narrow vote to leave the European Union in 2016, was specific to the UK. This led to political turmoil and protracted negotiations over the terms of the trade deal after the UK left. This uncertainty has been exacerbated recently by the series of global shocks highlighted above and also the budget uncertainty of Liz Truss’s short-lived premiership and now the growing pressure to reduce government borrowing.
While spikes in uncertainty occurred before the financial crises, the average level of uncertainty, as measured by the index, has been much higher since the crisis. From 1998 to 2008, the average value was 89. Since 2008, the average value has been 163. Since the Brexit vote, the average value has been 185. This indicates a much higher perception of risk and uncertainty over the past 15 year and this translates into higher minimum expected return as compensation. Consequently, this makes many long-term investment projects less viable because of higher hurdle rates. This produces less productive investment in capital, contributing significantly to lower productivity.
Policy proposals
There has been much debate in the UK about promoting greater long-term investment. Reforms have been proposed to improve public participation in long-term investment through the stock market. To boost investment, this would require the investing public to be prepared to accept lower expected returns for a given level of risk or accept higher risk for a given level of returns.
Evidence suggests that the appetite for this may be very low. UK savers tend to favour less risky and more liquid cash deposits. It may be difficult to encourage them to accept higher levels of risk. In any case, even if they did, many may invest outside the UK where the risk-return trade-off is more favourable.
Over the past 10 years, policy uncertainty has played a significant role in deterring investment. So, if there is greater continuity, this may then promote higher levels of investment.
The Labour government has proposed policies which aim to share or reduce the risk/uncertainty around long-term investment for UK businesses. For instance, a National Wealth Fund (NWF) has been established to finance strategic investment in areas such as clean energy, gigafactories and carbon capture. Unfortunately, the Fund is financed by borrowing through financial markets and the amount expected to be committed over the life of the current Parliament is only £29 billion, assuming that private capital matches public commitments in the ratio expected. It is questionable whether the Fund’s commitment will be sufficient to attract private capital.
Alternatively, Invest 2035 is a proposal to create a stable, long-term policy environment for business investment. It aims to establish an Industrial Strategy Council for policy continuity and to tackle issues like improving infrastructure, reducing energy costs and addressing skills gaps. Unfortunately, even if there is some attempt at domestic policy stability, the benefits may be more than offset by perceptions around global uncertainty, which may mean that UK investors’ minimum expected rates of return remain high and long-term investment low for the foreseeable future.
Articles
Data
Questions
- Use the marginal efficiency of capital framework to illustrate the ‘lost’ investment spending in the UK due to the investment hurdle rate being higher than the cost of capital.
- Explain the arbitrage process which produces the differences in valuations of UK securities and foreign ones due to differences in the expected rate of return.
- Sketch an indifference curve for a risk-averse investor, treating expected return and risk as two characteristics of a financial instrument.
- How does higher uncertainty affect the slope of an indifference curve for such an investor? How does this affect their investment hurdle rate?
- Analyse the extent to which the proposed polices can reduce the investment hurdle rate for UK companies and encourage greater levels of investment.
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)?
Over the decades, economies have become increasingly interdependent. This process of globalisation has involved a growth in international trade, the spread of technology, integrated financial markets and international migration.
When the global economy is growing, globalisation spreads the benefits around the world. However, when there are economic problems in one part of the world, this can spread like a contagion to other parts. This was clearly illustrated by the credit crunch of 2007–8. A crisis that started in the sub-prime market in the USA soon snowballed into a worldwide recession. More recently, the impact of Covid-19 on international supply chains has highlighted the dangers of relying on a highly globalised system of production and distribution. And more recently still, the war in Ukraine has shown the dangers of food and fuel dependency, with rapid rises in prices of basic essentials having a disproportionate effect on low-income countries and people on low incomes in richer countries.
Moves towards autarky
So is the answer for countries to become more self-sufficient – to adopt a policy of greater autarky? Several countries have moved in this direction. The USA under President Trump pursued a much more protectionist agenda than his predecessors. The UK, although seeking new post-Brexit trade relationships, has seen a reduction in trade as new barriers with the EU have reduced UK exports and imports as a percentage of GDP. 
According to the Office for Budget Responsibility’s November 2022 Economic and Fiscal Outlook, Brexit will result in the UK’s trade intensity being 15 per cent lower in the long run than if it had remained in the EU.
Many European countries are seeking to achieve greater energy self-sufficiency, both as a means of reducing reliance on Russian oil and gas, but also in pursuit of a green agenda, where a greater proportion of energy is generated from renewables. More generally, countries and companies are considering how to reduce the risks of relying on complex international supply chains.
Limits to the gains from trade
The gains from international trade stem partly from the law of comparative advantage, which states that greater levels of production can be achieved by countries specialising in and exporting those goods that can be produced at a lower opportunity cost and importing those in which they have a comparative disadvantage. Trade can also lead to the transfer of technology and a downward pressure on costs and prices through greater competition.
But trade can increase dependence on unreliable supply sources. For example, at present, some companies are seeking to reduce their reliance on Taiwanese parts, given worries about possible Chinese actions against Taiwan.
Also, governments have been increasingly willing to support domestic industries with various non-tariff barriers to imports, especially since the 2007–8 financial crisis. Such measures include subsidies, favouring domestic firms in awarding government contracts and using regulations to restrict imports. These protectionist measures are often justified in terms of achieving security of supply. The arguments apply particularly starkly in the case of food. In the light of large price increases in the wake of the Ukraine war, many countries are considering how to increase food self-sufficiency, despite it being more costly.
Also, trade in goods involves negative environmental externalities, as freight transport, whether by sea, air or land, involves emissions and can add to global warming. In 2021, shipping emitted over 830m tonnes of CO2, which represents some 3% of world total CO2 emissions. In 2019 (pre-pandemic), the figure was 800m tonnes. The closer geographically the trading partner, the lower these environmental costs are likely to be.
The problems with a globally interdependent world have led to world trade growing more slowly than world GDP in recent years after decades of trade growth considerably outstripping GDP growth. Trade (imports plus exports) as a percentage of GDP peaked at just over 60% in 2008. In 2019 and 2021 it was just over 56%. This is illustrated in the chart (click here for a PowerPoint). Although trade as a percentage of GDP rose slightly from 2020 to 2021 as economies recovered from the pandemic, it is expected to have fallen back again in 2022 and possibly further in 2023.
But despite this reduction in trade as a percentage of GDP, with de-globalisation likely to continue for some time, the world remains much more interdependent than in the more distant past (as the chart shows). Greater autarky may be seen as desirable by many countries as a response to the greater economic and political risks of the current world, but greater autarky is a long way from complete self-sufficiency. The world is likely to remain highly interdependent for the foreseeable future. Reports of the ‘death of globalisation’ are premature!
Podcasts
Articles
Report
Questions
- Explain the law of comparative advantage and demonstrate how trade between two countries can lead to both countries gaining.
- What are the main economic problems arising from globalisation?
- Is the answer to the problems of globalisation to move towards greater autarky?
- Would the expansion/further integration of trading blocs be a means of exploiting the benefits of globalisation while reducing the risks?
- Is the role of the US dollar likely to decline over time and, if so, why?
- Summarise Karl Polanyi’s arguments in The Great Transformation (see the Daniel W. Drezner article linked below). How well do they apply to the current world situation?
International wholesale gas prices have soared in recent months. This followed a cold winter in 2021/22 across Europe, the bounceback in demand as economies opened up after COVID and, more recently, pressure on supplies since the Russian invasion of Ukraine and the resulting restricted gas supplies from Russia. The price of gas traded on the UK wholesale market is shown in Chart 1 (click here for a PowerPoint). Analysts are forecasting that the wholesale price of gas will continue to rise for some time. The higher price of gas has had a knock-on effect on wholesale electricity prices, as gas-fired power stations are a major source of electricity generation and electricity prices.
In the UK, domestic fuel prices were capped by the regulator, Ofgem. The cap reflected wholesale prices and was designed to allow electricity suppliers to make reasonable but not excessive profits. The cap was adjusted every six months, but this was been reduced to three months to reflect the rapidly changing situation. Prices are capped for both gas and electricity for both the standing charge and the rate per kilowatt hour (kWh). This is illustrated in Chart 2 (click here for a PowerPoint).
The effects of the cap were then projected in terms of a total annual bill for a typical household consuming 12 000 kWh of gas and 2900 kWh of electricity. Chart 3 shows the typical fuel bill for the last four price caps and, prior to the mini-Budget of 23 September, the projected price caps for the first and second quarters of 2023 based on forecasts at the time of wholesale prices (click here for a PowerPoint). As you can see, wholesale gas and electricity prices account for an increasing proportion of the total bill. The remaining elements in cost consist of profits (1.9% assumed), VAT (5%), operating costs, grid connection costs and green levies (around £153). The chart shows that, without government support for prices, the price cap would have risen by 80.6% in October 2022 and was projected to rise by a further 51% in January 2023 and by another 23% in March 2023. If this were to have been the case, then prices would have risen by 481% between the summer of 2021 and March 2023.
This was leading to dire warnings of extreme fuel poverty, with huge consequences for people’s health and welfare, which would put extra demands on an already stretched health service. Many small businesses would not be able to survive the extra fuel costs, which would lead to bankruptcies and increased unemployment.
Future wholesale gas prices
Energy market analysts expect wholesale gas prices to remain high throughout 2023, with little likelihood that gas supplies from Russia will increase. Some European countries, such as Germany, have been buying large amounts of gas to fill storage facilities before winter and before prices rise further. This has added to demand.
The UK, however, has only limited storage facilities. Although it is not an importer of gas from Russia and so, in one sense, storage facilities are less important at the current time, wholesale gas prices reflect international demand and supply and thus gas prices in the UK will be directly affected by an overall global shortage of supply.
What would have been the response to the projected rise in gas prices? Eventually demand would fall as substitute fuels are used for electricity generation. But demand is highly inelastic. People cannot readily switch to alternative sources of heating. Most central heating is gas fired. People may reduce consumption of energy by turning down their heating or turning it off altogether, but such reductions are likely to be a much smaller percentage than the rise in price. Thus, despite some use of other fuels and despite people cutting their energy usage, people would still end up spending much more on energy.
Over the longer term, new sources of supply of gas, including liquified natural gas (LNG), may increase supply. And switching to green energy sources for electricity generation, may bring the price of electricity back down and lead to some substitution been gas and electricity in the home and businesses. Also improved home insulation and the installation of heat pumps and solar panels in homes, especially in new builds, may reduce the demand for gas. But these changes take time. Chart 4 illustrates the situation (click here for a PowerPoint).
Both demand and supply are relatively inelastic. The initial demand and supply curves are D1 and S1. Equilibrium price is P1 (point a). There is now a fall in supply. Supply shifts to S2. With an inelastic demand, there is a large rise in price to P2 (point b).
Over two or three years, there is a modest fall in demand (as described above) to D2 and a modest rise in supply to S3. Price falls back somewhat to P3 (point c). Over a longer period of time, these shifts would be greater and the price would fall further.
Possible policy responses
What could the government do to alleviate the problem? Consensus was that the new Conservative Prime Minister, Liz Truss, and her Chancellor, Kwasi Kwarteng, would have to take radical measures if many households were to avoid severe hardship and debt. One proposal was to reduce VAT on domestic energy from 5% to zero and to cut green levies. Although this would help, it would make only a relatively small dent in people’s rising bills.
Another proposal was to give people cash payments to help with their bills. The more generous and widespread these payments, the more costly they would be.
One solution here would be to impose larger windfall taxes on oil and gas producers (as opposed to retailers). Their profits have soared as oil and gas prices have soared. Such a move is generally resisted by those on the right of politics, arguing that it could discourage investment in energy production. Those on the centre and left of politics argue that the profits are the result of global factors and not because of wise business decisions by the energy producers. A windfall tax would only take away these excess profits.
The EU has agreed a tax on fossil fuel companies’ surplus profits made either this year or next. It is also introducing a levy on the excess revenues that other low-cost power producers make from higher electricity prices.
Another proposal was to freeze retail energy prices at the current or some other level. This would make it impossible for energy suppliers to cover their costs and so they would have to be subsidised. This again would be very expensive and would require substantially increased borrowing at a time when interest rates are rising, or increased taxation at a time when people’s finances are already squeezed by higher inflation. An alternative would be to cap the price North Sea producers receive. As around half of the UK’s gas consumption is from the North Sea, this would help considerably if it could be achieved, but it might be difficult to do so given that the gas is sold onto international markets.
One proposal that was gaining support from energy producers and suppliers is for the government to set up a ‘deficit fund’. Energy suppliers (retailers) would freeze energy prices for two years and take out state-backed loans from banks. These would then be paid back over time by prices being capped sufficiently high to cover costs (which, hopefully, by then would be lower) plus repayments.
Another policy response would be to decouple electricity prices from the wholesale price of gas. This is being urgently considered in the EU, and Ofgem is also consulting on such a measure. This could make wholesale electricity prices reflect the costs of the different means of generation, including wind, solar and nuclear, and would see a fall in wholesale electricity prices. At the moment, generators using these methods are making large profits.
The government’s response
On September 23, the government held a mini-Budget. One of its key elements was a capping of the unit price of energy for both households and firms. The government called this the Energy Price Guarantee. For example, those households on a variable dual-fuel, direct-debit tariff would pay no more than 34.0p/kWh for electricity and 10.3p/kWh for gas. Standing charges are capped at 46p per day for electricity and 28p per day for gas. These rates will apply for 2 years from 1/10/22 and should give an average annual household bill of £2500.
Although the government has widely referred to the ‘£2500 cap’, it is the unit price that is capped, not the annual bill. It is still the case that the more you consume, the more you will pay. As you can see from Chart 3, the average £2500 still represents an average increase per annum of just over £500 per household and is almost double the cap of £1277 a year ago. It will thus still put considerable strain on many household finances.
For businesses, prices will be capped for 6 months from 1 October at 21.1p per kWh for electricity and 7.5p per KWh for gas – considerably lower than for domestic consumers.
The government will pay subsidies to the retail energy companies to allow them to make sufficient, but not excess, profit. These subsidies are estimated to cost around £150 billion. This will be funded by borrowing, not by tax increases, with the government ruling out a windfall tax on North Sea oil and gas extracting companies. Indeed, the mini-Budget contained a number of tax reductions, including scrapping the 45% top rate of income tax, cutting the basic rate of income tax from 20% to 19% and scrapping the planned rise in corporation tax from 19% to 25%.
Articles
Data
Questions
- Why are the demand and supply of gas relatively inelastic with respect to price?
- Why are the long-run elasticities of demand and supply of gas likely to be greater than the short-run elasticities?
- Find out how wholesale electricity prices are determined. Is there a case for reforming the system and, if so, how?
- Identify ways in which people could be protected from rising energy bills.
- Assess these different methods in terms of (a) targeting help to those most in need; (b) economic efficiency.
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.
