A2 & AS Economics: UK Economy Revision Briefing

A2 and AS Revision – April 2013
Developments in the UK Economy
Macroeconomic performance – an overview
Indicator 2008 2009 2010 2011 2012 2013
Real GDP (% change) -1.0 -4.0 1.8 0.9 -0.1 0.9
Consumer spending (% change) -1.6 -3.1 1.3 -0.9 1.1 1.6
Government current spending (% change) 1.6 0.8 0.4 0.2 1.3 -3.0
Capital investment (% change) -4.6 -13.7 3.5 -2.4 1.8 2.5
Exports of goods and services (% change) 1.2 -8.2 6.4 4.5 -0.2 2.4
Imports of goods and services (% change) -1.8 -11.0 8.0 0.5 2.8 2.6
Output gap - as a percentage of potential GDP 2.0 -2.8 -1.7 -1.4 -2.2 -2.3
Unemployment rate - as a percentage of labour force 5.7 7.6 7.9 8.1 8.0 8.3
Fiscal balance - as a percentage of GDP -5.0 -10.9 -10.1 -8.3 -6.6 -6.9
Money market short term interest rates - per cent 5.5 1.2 0.7 0.9 0.9 0.7
CPI inflation - per cent 3.6 2.2 3.3 4.5 2.6 1.9
BoP Current account balance - as a percentage of GDP -1.0 -1.3 -2.5 -1.9 -3.3 -3.5

Source: OECD World Economic Outlook, December 2012. Data for 2013 is an OECD forecast

1. Output: Real GDP remains well below output levels before the recession began. GDP has recovered at a
pace of just 1% annualised since the end of the recession.
2. Fragility: Recovery from the recession has been weak and fragile. Output grew by less than 1% in 2011
and actually fell again in 2012. According to the National Institute for Economic Research, “This period of
depressed UK output is now significantly longer than that experienced during the Great Depression.”
3. Weak private sector: A key weakness for the UK has been the low growth of private sector demand. A
number of factors are holding back consumption including falling real incomes, low confidence, high levels
of existing household debt and the high cost of unsecured loans. Stagnant house prices also a factor.
4. Low investment: Business capital spending has also been low – it collapsed by nearly 14% in 2009 and
has struggled to recover momentum ever since despite many businesses holding record levels of cash.
Lots of businesses seem to be reluctant to give the go-ahead for new capital projects.
5. Credit scarcity: The private sector in the UK has been weak in part because of the lack of credit from the
financial system. Many commercial banks continue to de-leverage (cut their loan books) and business
finance is hard to get at an affordable rate of interest. Several policies have been introduced in the last two
years to encourage more lending, but with mixed results thus far – latest is Funding for Lending
6. Slow export growth: Exports were expected to be a driver of recovery for the UK but after two relatively
good years in 2010 and 2011, the rate of growth of exports sold overseas has dropped once more.
7. Spare capacity: The result of weak growth in the last few years is that the UK economy is operating with a
negative output gap – GDP is well down on potential output and one consequence is a high rate of
unemployment. That said, the 8% unemployment rate is lower than after previous recessions although
long-term unemployment and youth jobless rates are two difficult structural problems
8. Fiscal debt and fiscal austerity: The high level of government borrowing is shown in the table with figures
for the annual fiscal deficit. Peaking at over 10% of GDP in 2009 and 2010, the Coalition government have
made deficit reduction a key pillar of their macroeconomic policies and have focused on spending cuts
rather than tax rises as part of their fiscal austerity programme.
9. Inflation and real incomes: Inflation in the UK has been above the 2% target for CPI over most of the last
five years. External factors such as high global commodity prices, a weaker currency and the rising price of
energy have been three important reasons for inflation staying above target range. Persistently above
target inflation has cut real incomes.
10. Trade deficits: The UK continues to run a current account deficit on the balance of payments, the main
reason for this is the widening trade deficit in goods which rose above £100bn for the first time in 2011.

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Growth in the UK Economy

Output for the UK economy in the recession in the years 2008-09 fell by 6% from peak to trough and recovery
since then has been slow and fragile. The UK suffered a deeper recession and has seen a weaker recovery
than many other nations. Several factors help to explain this slow growth:
Falling consumer spending as real incomes fall and people have struggled to pay off existing debts
Low business confidence and weak demand has held back capital investment spending
Export growth has been affected by low demand in the EU (Britain‟s biggest export markets) and
difficulties among exporting businesses in securing export finance / trade credit
Increasingly deep cuts in the real level of government spending and rising taxes as part of the
Coalition‟s fiscal austerity programme
Demand has not responded as much as expected to a period of expansionary monetary policy
including record low base interest rates, quantitative easing and a new credit easing scheme

Restoring growth and re-balancing the economy
Two key macroeconomic aims for the government are firstly to restore growth as a way of generating new
jobs. Secondly the aim is to re-balance the economy away from debt-financed consumption and imports,
towards higher levels of exports and investment (X and I in the AD equation).

Re-balancing policies have included:
1. Currency depreciation (a fall in the external value of sterling against other currencies)
a. A boost to UK export competitiveness – it makes UK unit labour costs and prices lower
b. Improved net trade balance (over time) – providing export demand responds
2. Supply-side support for industry
a. Establish more technology innovation centres
b. Increase number of graduates and apprentices in technical subjects
c. Lower corporation tax – reduced to 21% in the March 2013 budget
3. Improving the supply of credit in the financial system
a. Project Merlin – a voluntary agreement with the banks
b. Credit easing scheme – government loan guarantees
c. Funding for lending scheme (FLS)
d. Green Investment Bank for renewable investment schemes
e. Encouraging new entrants into the retail banking industry


Drivers of growth for the UK
Economic growth is a sustained rise in a nation‟s productive potential. For an advanced high-income country,
the sources of growth are subtly different from a lower-income emerging / developing country. The natural rate
of population growth tends to be lower and per capita incomes have reached a level where rapid percentage
improvements are hard to come by. Growth can flow from several sources – including:

Labour Market
Innovation and
Participation i.e. Capital investment to
Productivity Enterprise -
increasing the boost capacity and
Improvements - an encouraging businesses
percentage of the lower unit costs.
increase in capital and and industries that can
population of working Includes infrastructure
labour input efficiency create high value
age who are investment projects
added products
economically active

The estimated growth of potential GDP for the UK is estimated by economists to have fallen in recent years.
The OECD‟s projected UK trend growth rate (the annual rise in long run aggregate supply) declined from 2.5%
in 2006 to less than 1% in 2010 and 2011. For the period 2012-2014 it is likely to remain below two per cent.
Why might the UK economy have to suffer from a prolonged period of slow growth?

1. Low research and development spending as a share of GDP
2. Falling share of capital investment as a share of GDP (low business confidence)
3. Slow economic growth in the European Union – Britain‟s biggest market for exporting products
4. Volatile and regressive housing sector causing low labour mobility
5. Few small/medium businesses export to emerging countries
6. High long-term unemployment is a major drag on economy – this is creating hysteresis problems
7. A creaking national infrastructure, other countries overtaking in terms of transport networks and
telecommunications capacity and speed
8. Financial system continues to be fragile with low lending to businesses – the credit crunch in the UK
has effectively lasted for six years now
9. There are signs now of a productivity slowdown in the UK economy. Output per worker in the UK at the
end of 2012 was lower than it had been at the end of 2006
10. Fiscal austerity – deep cuts in government spending and higher taxes are likely to be a major constraint
on demand and output in the UK for a few more years yet


UK - Potential GDP and Trend Growth
Source: OECD World Economic Outlook
9 9
Per cent

8 8
7 7
6 Unemployment rate (%) 6
5 5
4 4
3 Estimated UK Trend Growth Rate 3
2 2
1 1
0 0
-1 % Change in Employment -1
-2 -2
-3 -3
-4 -4
04 05 06 07 08 09 10 11 12 13 14

What are the implications for the UK economy and government policy if trend growth remains at a low level?

United Kingdom Labour Productivity
Index of output per hour worked, whole economy, seasonally adjusted
105 105

100 100

95 95

90 90
Index

85 85

80 80

75 75

70 70

65 65
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Source: Reuters EcoWin

Labour productivity growth in the UK appears to have stalled in recent years – partly this might be the result of
the recession and slow/weak economic recovery. But what supply-side factors might also explain the low rate
of growth of output per hour worked?


Monetary Policy in the UK

Monetary Policy Interest Rates, GDP Growth and CPI Inflation in the UK
per cent
4 4
Percent

Percent
3 3
2 2
1 Real GDP Growth Rate 1
0 0
-1 -1
-2 -2
-3 -3
-4 -4

7 7
Percent

Percent
Policy Interest Rates
6 6

5 5

4 4

3 3

2 2

1 Consumer price index 1

0 0

-1 -1

-2 -2
04 05 06 07 08 09 10 11 12 13

Source: UK Statistics Commission

Monetary policy works by changing the rate of growth of demand for money; changes in interest rates
affect the spending and savings behaviour of households and businesses
Because of the time lags involved in setting an appropriate level of interest rates, in the UK the Bank of
England sets rates on the basis of hitting the inflation target of 2% for the consumer price index over a
two year forecasting horizon
The Bank of England has been independent since 1997
The UK operates within a floating exchange rate system and has done since we left the exchange rate
mechanism (ERM) in 1992. Changes in policy interest rates still have an effect on the demand and
supply of currencies in the foreign exchange rate markets
Since 2009 the BoE has operated a policy of quantitative easing as an extra tool of monetary policy
The policy of ultra-low interest rates

Ultra-low interest rates are an example of accommodatory monetary policy i.e. a policy designed to deliberately
boost AD and output. In theory cutting nominal interest rates close to zero provides a big monetary stimulus to
the economy:
Mortgage payers have less interest to pay – increasing their effective disposable income
Cheaper loans should provide a possible floor for house prices in the property market
Businesses will be under less pressure to meet interest payments on their loans
The cost of credit should fall encouraging the purchase of items such as a new car or kitchen
Lower interest rates might cause a depreciation of sterling boosting the competitiveness of exports
Lower rates are designed to boost consumer and business confidence


Rate of Growth of Bank Lending to UK Sectors
12 month growth rate in lending, seasonally adjusted, per cent
40 40
Annual percentage change

Annual percentage change
30 30

20 20

10 10

0 0

-10 -10

-20 -20
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3
05 06 07 08 09 10 11 12
Construction Manufacturing
Hotels and restaurants Total lending to UK businesses
Source: Bank of England

Some economists argue that in current circumstances, the usual transmission mechanism for monetary policy
may have broken down and that cutting interest rates has little effect on demand, production and prices.
Several reasons have been put forward for this:
1) The unwillingness of banks to lend – most banks are de-leveraging (cutting the size of loan books)
2) The incentive to lend when interest rates are at such low levels is reduced
3) Low consumer confidence – people are not prepared to commit to major purchases – recession has
made people risk averse as unemployment rises. Weak expectations lower the effect of rate changes
on consumer demand – i.e. there is a low interest elasticity of demand.
4) Huge levels of debt still need to be paid off including over £200bn on credit cards
5) Falling asset prices – and expectations that property prices will continue to fall
The chart above shows how bank lending to various sectors of the economy has remained weak since 2009. A
negative growth rate means that the annual level of lending is falling.

The Liquidity Trap

In the 1930s, Keynes referred to a liquidity trap effect – a situation where the central bank cannot lower nominal
interest rates any lower and where „conventional‟ monetary policy loses its ability to impact on spending. Paul
Krugman has defined the liquidity trap as “a situation in which conventional monetary policy loses all traction.”

When interest rates are close to zero, people may expect little or no real rate of return on their financial
investments they may choose instead simply to hoard cash rather than investing it. This causes a fall in the
velocity of circulation of money and means that an expansionary monetary policy appears to become impotent.
This means that different approaches are called for in order to stabilize demand in an economy on the verge of
a depression including quantitative easing


Sterling Exchange Rate

The UK operates with a free-floating exchange rate
The external value of sterling is determined by market forces of supply and demand
Sterling depreciated by more than 20% from late 2007 through to the end of 2008
The effective exchange rate index measures the overall value of sterling against a weighted basket of
leading currencies
Since 2009 sterling has been fairly stable although there was appreciation in the first half of 2012
A lower exchange rate was a helpful boost to the UK‟s competitiveness during the worst of the financial
crisis and the subsequent recession
It has helped to achieve a modest re-balancing of the economy towards exports, but the expansionary
effect of a lower pound has been limited by a number of other factors:
o High income elasticity of demand for imported goods and services
o Some weaknesses on supply-side of the economy (i.e. research / investment) – a fall in the
exchange rate does not fundamentally change a country‟s non-price competitiveness
o Many UK businesses are finding it hard to finance a rise in exports (credit squeeze)
o The majority of UK exports go to slow-growing countries in Europe and USA


Fiscal Policy in the UK Economy
Fiscal policy has become a crucial battleground in economic policy-making in the UK. The current Coalition
government has introduced a policy of fiscal austerity in a bid to cut the size of the annual fiscal deficit, limit the
rise in national debt and protect the UK‟s triple AAA credit rating in global capital markets.

UK Government Spending and Taxation
Measured as a percentage of national income (2010-11 is a forecast from the OECD)
52.5 52.5
Per cent of GDP

Per cent of GDP
50.0 50.0

47.5 47.5

Total Government Spending
45.0 45.0

42.5 42.5

Total Tax Revenue
40.0 40.0

37.5 37.5

35.0 35.0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14


Government spending as a share of GDP peaked at over 50% of GDP in 2009 and is forecast to fall to 46% by
2014. The tax burden (measured by the share of total taxes in GDP) has remained relatively constant. Some
taxes have risen (e.g. VAT to 20%) whilst others have fallen (including cuts to corporation tax). The difference
between G and T as a share of GDP tells us the annual budget / fiscal balance. For example a fiscal deficit of
6% of GDP is forecast for 2014.

The size of the UK fiscal deficit is determined by a number of factors:

Rate of unemployment and the rate of inflation – more people out of work causes welfare bills to rise,
inflation causes an annual increase in most benefits although the government now seeks to cap annual
rises to 1%
Growth of real incomes and profits – slow growth and weak profits hits tax revenues flowing into the UK
Treasury
Scale of government spending including welfare – the coalition prefers cuts in real spending on public
sector services over tax rises as their strategy for cutting the fiscal deficit
Effects of changes in tax rates on both direct and indirect taxes


A2 & AS Economics: UK Economy Revision Briefing

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