Economics The UK Economy [INTERMEDIATE 2;

NATIONAL QUALIFICATIONS CURRICULUM SUPPORT

Economics

The UK Economy

[INTERMEDIATE 2;

HIGHER]

Martin Duguid

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Scotland or others, are reminded that it is their responsibility to check that the support materials correspond to the requirements of the current arrangements.

Acknowledgement

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Qualifications support programme for Economics.

© Learning and Teaching Scotland 2005

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2 INTERMEDIATE 2/HIGHER ECONOMICS


Contents

Unit 2: The UK Economy

Topic 1: National income

Topic 2: Inflation and unemployment

Topic 3: The role of government in the economy

Topic 4: Government economic policies ( for Higher only )

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41

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THE UK ECONOMY

Unit 2

Topic 1: National Income

1 What is national income?

1.1 National income is the value of all goods and services that are produced by an economy in a year. It is a measure of a country’s economic performance.

1.2

A country’s economic performance can be measured in different ways.

Three common measures are:

• Gross Domestic Product

• Gross National Product

• Net National Product.

Gross Domestic Product (GDP) is the output of goods and services produced within the UK in a year.

Gross National Product (GNP) is the output produced by UK -owned resources. This differs from GDP in that some output produced within the country is produced by foreign -owned resources and some of the output from UK-owned businesses is produced overseas. GNP is GDP plus the value of output produced overseas by UK -owned resources minus the value of output produced in the UK by foreign -owned resources.

Net National Product is GNP less depreciation, i.e. the loss in value of capital goods during the year. NNP is ‘new’ output, i.e. the addition to the country’s stock of goods (i.e. its wealth).

Net National Product is the true measure of national income but you will find that commentators may use any of these three measures as ‘nation al income’.

2 National income and inflation: nominal income and real income

All of the above measures of economic performance may be expressed in nominal terms or real terms.



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2.1 Nominal or money terms . When national income is expressed in nominal terms (sometimes called money terms), this means that its value has been calculated by using the prices of the time, i.e. current prices.

Measuring value in money terms makes it difficult to compare one year’s output with another year’s since an increase in n ational income could have been caused by inflation, i.e. the value may have gone up because of a rise in prices and not by an increase in output. To measure changes in output, it is necessary to convert figures to real terms.

2.2 Real terms . Expressing national income in real terms means measuring output as if there had been no inflation, i.e. at constant prices. It means that value has been adjusted to remove the inflation element. So an increase in real national income means that there has been an increa se in the quantity of goods and services produced.

2.3 Method of adjustment

Real national income =

Nominal national income



1

Price index of base year

Price index of current year

Example

Year 1

Money value of national income

Index of prices

Year 2

£10,000m

100

£12,000m

105

Calculation:

Real national income for Year 1 =

£10,000m

1



100

100



Real national income for Year 2 =

£12,000m

1



100

105



Nominal income increased by 20%.

Real income increased by 14%.

3 National income may be calculated in three different ways

3.1 The output method . This method adds the value of goods and services produced by all firms in both the private and public sectors.



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Care must be taken to avoid double counting, i.e. counting the same output more than once, e.g. when the output of one firm, stee l, becomes the input of another, cars. Only the value added to each stage of production, i.e. the value of work done by each producer, should be included.

3.2 The income method . The incomes earned by the owners of all resources used in production are added up, i.e. the total amount of rent, wages, interest and profit earned.

Transfer incomes such as pensions and benefits should not be included as those who receive them are not involved in producing output.

3.3 The expenditure method . This method totals the spending of individuals, firms, government and foreign buyers on goods and services.

Spending on imports is deducted as it represents output created by other countries.

4 Uses of national income statistics

National income is a measure of economi c activity in an economy. The figures have a number of uses. They can be used:

(a) to measure economic growth and changes in the standard of living in a country

(b) to help government assess the state of the economy and plan future policy

(c) to compare the economic performance and standards of living of different countries

(d) to identify countries that are in need of aid

(e) to calculate the contributions which countries should make to international organisations, e.g. the World Bank and the EU.



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5 Problems of measuring national income

If national income figures are to be used for measuring and comparing economic activity then they need to be accurate. However there are a number of reasons why the statistics may be inaccurate:

(a) Errors and omissions occur in collecting and calculating the statistics.

(b) People deliberately hide what they earn or what they produce in order to avoid tax or claim benefit – this is known as the ‘black economy’.

(c) Under-recording of output where the production of some goods and services is not recorded because they are not exchanged for money, e.g. housework, barter trade and DIY activities.

(d) Over-recording of output where double counting occurs (see 3.1).

(e) Over-recording of income when transfer incomes a re included

(see 3.2).

6 Difficulties in using national income statistics for making comparisons over time or between countries

National income figures are used to compare changes in standards of living but there are difficulties:

(a) Methods of calculating national income may differ over time or between countries.

(b) Levels of self-sufficiency may differ – the more self-sufficient people are, the more output will be under -recorded.

(c) Standard of living is measured by income per person (per capita) so population changes must also be measured. Accuracy of comparisons between years or between countries therefore also depends on the accuracy of population figures.



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(d) Statistics have to be adjusted for inflation – accuracy depends on accuracy of inflation figures.

(e) Statistics do not show differences in the range, design and quality of goods and services.

(f) Statistics do not show differences in working conditions, hours and leisure time.

(g) Statistics do not show differences in income distribu tion – distribution of an increase in national income amongst citizens may be inequitable, so although the average per capita income rises, the standard of living of all citizens may not.

(h) Social costs are not taken into account, e.g. the output of ca rs is recorded but their associated social costs of pollution and congestion are not.

(i) Spending on defence or space may account for an increase but may do little for the standard of living of the people.

Circular Flow of National Income

1 Introduction

In its simplest form an economy consists of firms and households (a two-sector economy). Households own factors of production which they provide to firms. In return for land, labour, capital and enterprise to firms they receive income in the form of rent, wages, interest and



THE UK ECONOMY profit. These incomes are spent in buying the output of goods and services made by firms and this expenditure becomes incomes for firms which in turn is used to pay incomes to households and so on. Thus a circular flow of income is created. Therefore the total value of output should equal the total expenditure on goods and services and should equal the total income of households.

National output = National expenditure = National income.

2 Consumer spending (C)

This is the value of consumer goods and services demanded in a particular period of time. Consumer spending is a function of income.

This means that as income changes then so does consumer spending.

The average propensity to consume (APC) income which is spent.

is the proportion of total

APC =

Consumption

Income

An APC of 1 means that 100% of income is spent. An APC of 0.9 means that 90% of income is spent. People on low incomes are likely to have an APC of 1. As income rises, average propensi ty to consume tends to fall as consumers increase the proportion of their income which they save. (Note that although the proportion of income spent on consumption falls, the amount spent rises.) It follows that if a consumer has an APC of 1 there is no saving, i.e. average propensity to save

(APS) = 0, and if APC = 0.9 then APS = 0.1.



APC + APS = 1

The marginal propensity to consume (MPC) is the proportion of any increase in income which consumers would spend on consumption.

MPC =

Increase in Consumption

Increase in Income

A MPC of 0.8 means that 80% of any increase in income would be spent on consumption. It follows that the marginal propensity to save

(MPS) would be 0.2



MPC + MPS = 1



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Injections and leakages from the circular flow

3 Injections

An injection is any spending in the economy which is not consumer spending. Investment, export buying and government spending are injections into the circular flow of national income. Note that their size is not determined by the size of national in come. Injections are said to be autonomous of national income.

4 Leakages

A leakage is a withdrawal of funds from the circular flow of income between firms and households.

Savings, imports and taxation are leakages from the circular flow of income. Not e that the size of each depends on the size of national income. Leakages are said to be a function of national income.

5 Investment spending (I)

This is the value of capital goods demanded in a particular period. This is mainly determined by producers’ expectation of profit which in turn depends on:

• potential sales revenue

• the interest rate on the loans to buy the capital goods.



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6 Export buying (X)

This is the value of goods demanded by overseas firms and individuals.

This is mainly determined by the size of national incomes in foreign countries. Other determining factors include:

• the prices and quality of exports compared to those of competing countries

• delivery times and quality of after-sales service.

7 Government spending (G)

This is the value of spending by the public sector. This includes the demand for goods and services by central and local government departments; social benefits; and grants to the private sector. The level of government spending is mainly determined by polit ical decisions taken by government.

8 Savings (S)

These are the amount of money saved by individuals in a particular period of time. The main determinant is the level of income – the higher the level of income, the greater the proportion of income save d.

The proportion of income saved is called the propensity to save.

At very low levels of income consumption is greater than income, and dis-saving occurs, i.e. savings from a previous period are used, or the savings of others are borrowed to finance spending. Other influences on savings are:

• interest rates

• habit and attitude to saving

• extent of the precautionary motive.

9 Import spending (M)

This is the amount spent by the resident firms and individuals of a country on overseas goods and services. The main determinant is the level of income. Other influences are:

• the prices of imports relative to home-produced goods

• their quality and after-sales service.



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10 Taxation (T)

This is the amount of revenue collected by central and loc al government from taxation. The amount of revenue collected depends on the level of income and spending in the economy.

This section (to page 19) is for Higher only

The Determination of National Income

There are two schools of thought about how nation al income is determined.

Some economists believe that aggregate demand is the main determinant whilst others believe that it is aggregate supply. Others believe that both aggregate demand and supply are relevant. Economists who believe in the demand side of the economy as being the more important are called

Keynesians , named after the economist John Maynard Keynes who developed the theory in the 1930s.

Keynesianism: the Demand Side of the Economy

1 Link between national income and employment

The higher the level of national income (remember this is the same as national output) then the greater the number of workers who will be needed to produce it.

2 Full employment level of national income

This is the potential output of an economy, i.e. the maxim um output which could be produced if all resources are employed in producing those goods and services which they are best at producing.

3 Actual national income may be less than the full employment level

Why is this? One suggestion was provided by J M Keynes in an attempt to answer the massive unemployment of the 1930s when the economy had gone into a slump. The basis of his theory was that national income may settle at an equilibrium level which is below the full employment level.



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4 Equilibrium national income in a two-sector economy

4.1 The two-sector economy assumes that there is no government sector and that the economy is closed, i.e. there is no foreign trade.

4.2

Equilibrium level of national income is where aggregate demand equals income/output or where saving = investment. Aggregate demand is total expenditure. It is equal to consumption plus investment, i.e. the spending of consumers plus the spending of firms on capital goods.

In the following diagrams, an average propensity to consume o f 0.8 and an average propensity to save of 0.2 are assumed.

Diagram A: Equilibrium

Consumer

Spending

£80b

Aggregate demand = C + I = £80b + £20b = £100b

National income/output = £100b



Aggregate demand = National output

Saving (£20b) = Investment (£20b)



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Diagram B: not equilibrium

Consumer

Spending

£72b


National income/output = £90b

Saving £18b < Investment £20b

Demand is greater than output, so producers will increase production and hire more resources. This in turn will raise incomes and this will continue until equilibrium is reached.



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Diagram C: not equilibrium

Consumer

Spending

£88b


National income/output = £110

Demand < National income/output

Savings £22b > Investment £20b

Demand is less than output, so producers will notice the build -up in stocks and will cut back production. Workers will be laid off and incomes will fall until equilibrium is reached.



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5 Changes in equilibrium

5.1

Change in propensity to save . If consumers wish to save more out of their incomes, i.e. if the average propensity rises, it follows that they wish to spend less on consumption. Aggregate demand will fall, output/income will fall and so will employment. National income will fall until a new equilibrium is reached, i.e. where saving = investment.

5.2

Change in investment . An increase in investment raises aggregate demand. National income and employment will rise until equilibrium is restored, i.e. where savings = investment. A decrease in investment has the opposite effect. However, national income will change by more than the change in investment. This is because of the multiplier effect.

6 The multiplier

6.1 Keynes also developed the idea of the multiplier. He suggested t hat if there were any change in demand then national income would change by more. Any change in any component of aggregate demand would have a multiplier effect on national income. This can be explained by the investment multiplier.

6.2 The investment multiplier measures the change in national income resulting from a change in investment.

Change in national income = Change in investment x Multiplier

6.3 How the multiplier process works . Assume that in a two-sector economy with no government or external trade, consumers have a marginal propensity to consume of 0.9 and a marginal propensity to save of 0.1.

(a)

If a car manufacturer invests £100m in a new plant then this becomes £100m of income to those households which provide the resources. These households will spend £90m of their increased incomes on consumer products and save £10m.

(b) This £90m of consumer spending becomes £90m of income to those individuals who provided the resources to produce these consumer products. These individuals in turn wi ll spend £81m of this £90m of income on consumer products and save £9m.



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(c)

This £81m of spending becomes income to those individuals who provided the resources . . . etc.

This process continues until national income is back in equilibrium. At this point saving will again equal investment. In this example national income would increase £1000m.

Not only should you be able to describe the process in words, but you should also be able to show it in a circular flow diagram.

6.4 The size of the multiplier effect depends on the % of income spent on consumption and the % saved with each round of income. This depends on the marginal propensity to save.

The marginal propensity to save is the proportion of any change in income which is saved.



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MPS =

Change in savings

Change in income

Multiplier =

1 1

MPS

or

1 – MPC

If the MPS = 0.1, then the multiplier would be 10. National income would increase by ten times the amount of the increase in investment of

£100m to a new equilibrium level of income which would be £1000m higher than before. Savings would have increased by £100m which is equal to the increase in investment.

7 Equilibrium national income in an open economy

7.1 In a two-sector economy it is assumed that the economy is closed and that there is no government activity. In an open economy, there is government activity and international trade. This means that, as well as savings withdrawing income from the circular flow there will also be taxation and spending on imports. Government spending and the selling of exports will, in addition to investment, inject income into the circular flow. Aggregate demand in an open economy is therefore:

Aggregate demand = C + I + G + (X – M)

7.2 Equilibrium national income will still be where aggregate demand = national output/income. Because of the extra leakages and injections, at equilibrium:

S + T + M = I + G + X

7.3 The multiplier in an open economy . A change in any injection, I, G or

X will have a multiplier effect on national income. Remember from para 10.4 that the size of the multiplier effect depends on the proportion of any change in income which is consumed. In an open economy the

MPC will depend not only on the MPS but also on the proportion of any change in income which is spent on imports (the marginal propensity to import) and which is taken in tax (the marginal rate of tax). Spending on imports and taxation reduce the multiplier effect. For an open economy:

1

Multiplier =

1 – MPC

1 or =

MPS + MPM + MRT



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7.4 The importance of the multiplier

(a) An increase in any injection into the circular flow of income will increase national income by more than the increase in the injection.

(b) A decrease in any injection will decrease national income by more than the decrease in the injection.

(c) If government is planning to increase national income, e.g. to full employment level by increasing government spending then the increase does not have to be so large as the shortfall in national income.

8 The importance of Keynesianism

Keynes not only explained how national income was determined but also how it could be managed. The 1930s, when he published his theory, was a time of great depression in the world’s major economies.

He suggested that governments should intervene to increase aggregate demand in their economies by lowering taxes and incr easing government spending. Many governments adopted this policy and were able to reduce their unemployment. Governments continued to use demand-management policies after the Second World War until the late

1970s but when they found it difficult to control inflation there was a dramatic switch to monetarist policy.



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Monetarism – The Supply Side of the Economy

1 Introduction

While Keynesians believe that demand is the main determinant of national income, in contrast, monetarists believe that it is aggre gate supply. They believe that national output is determined by the quantity of resources available to an economy and their productivity. If resources are plentiful, easily available and cheap then producers will put them to work and this will create income for their owners which in turn will finance the demand for the output produced.

Note the contrast in views:

• Keynesians believe that demand creates supply , whereas

• Monetarists believe that supply creates demand.

2 Quantity and efficiency

Monetarists believe that an economy can increase the quantity and efficiency of its resources if it has the following characteristics:

(a) Private enterprise , operating in competitive markets, with minimum government intervention. The desire to make profit encourages producers to make as much output as possible as efficiently as possible.

(b) Low taxes on incomes . High income taxes discourage firms from earning high profits and discourage workers from earning high incomes.

(c) A flexible labour market . It should be easy for firms, facing falling demand for their products, to lower wages and shed labour; conversely, firms facing rising demand should find it easy to recruit labour and raise wages. Unemployment benefit should be low.

(d) Government should keep to a minimum regulations which add to firms’ costs, e.g. Health and Safety, minimum wage legislation, limits to working hours.

(e) Government should concentrate its efforts on improving the quality and efficiency of the workforce through education and training.



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Business/Trade Cycles

1 Introduction

It has long been observed in economics that income and employment tend to fluctuate regularly over time. These fluctuations are known as business cycles or trade cycles. The figure below shows the various stages of a business cycle.

Time in years

2 Peak or boom

When the economy is in a boom, some or all of the following characteristics are likely:

• Income and employment will be high.

• Wages and profits will be rising.

• Consumption and investment spending will be high.

• There will be inflationary pressures.

• Demand for imports will be high.

• Tax revenues will be high.

3 Recession

A recession is said to exist when there have been two successive quarters (3-month periods) of negative growth of real GDP (i.e. falling real GDP).



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Some or all of the following may happen:

• Income and employment fall. Note that unemployment is a ‘lagging indicator’ – it tends to rise some months after the recession starts but continues to rise even after a recovery starts.

• Wage demands moderate as unemployment rises.

• Consumption falls and investment spending falls as firms lose confidence in the future.

• Inflationary pressures moderate.

• Imports decline.

• Tax revenues begin to fall and government expenditure on benefits begin to rise.

4 Slump

In a slump, economic activity is low compared with surrounding years.

• Mass unemployment exists.

• Consumption and investment is low. Aggregate demand is low.

• There are few inflationary pressures.

• Demand for imports is low.

• Tax revenues are low and there is a large demand for state benefit.

5 Recovery

• Income and output begin to increase and so does employment.

• Consumption and investment begin to rise.

• Inflationary pressures begin to mount as workers feel more confident about demanding wage increases.

• Import spending begins to rise.

• Tax revenues start to rise and government spending on benefit starts to fall.



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Topic 2: Inflation and unemployment

Inflation

1 Definition

•

Inflation is a rise in the general level of prices. It does not mean that all prices are rising; some may rise while others fall or stay the same.

•

The rate of inflation is the percentage increase in the general level of prices in a period of time.

2 How is the general level of prices measured?

2.1

The Government measures changes in the prices of a number of different groups of goods and services and it publishes a number of price indices. Three such price indices are:

(a) RPI – the Retail Price Index – the ‘headline rate of inflation’.

(b) RPIX – the RPI without mortgage interest payments – the

‘underlying rate of inflation’.

(c) Consumer Price Index – the RPI without housing costs and council tax costs – this is the measure now used by the UK

Government to calculate the rate of inflation.

2.2 Retail Price Index. The RPI is a weighted average of the prices of those goods and services most commonly bought by households in the

UK.

It is calculated in the following way:

(a) The Family Expenditure Survey is used to identi fy a basket of the products bought by the majority of households.

(b) Each item in the basket is weighted according to the amount of spending on it, e.g. if 5% of consumer spending went on petrol then it would have weighting of 5%.

(c) A point in time is chosen as the base for the index.

(d) Each month the price of each item is compared and expressed as a percentage of its price at the base date. This price is called a price relative, e.g. if petrol increased in price from 50p per litre at the base date to a current price of 70p per litre it would have a price relative of 140.



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(e) The price relative is multiplied by its weighting and it would be included in the index as 140 x 5% = 7.

(f) This calculation is repeated for each item and the figures are added to give the weighted average total.

(g) Notice that the RPI at the base date would be 100.

Although no longer used by the UK Government to measure the general level of inflation it still uses changes in the RPI to uprate benefit levels.

2.3

RPIX. The Government believed that measuring changes in the RPIX was a better measure of inflation for the following reason.

The RPI includes mortgage costs which depend on interest rates. In recent years the change in interest rates has been the main policy weapon used by UK governments to control inflation. Increasing interest rates reduces inflation. However, a rise in interest rates has the more immediate consequence of raising mortgage costs and the RPI

(seemingly the opposite of what was intended). Excluding mo rtgage interest payments and using RPIX gave policy makers a better guide to how well their anti-inflation policy was working.

2.4 Consumer Price Index . In 2003 the Government introduced this new index. Its official title is the Harmonised Index of Consumer Prices but this mouthful is usually referred to as the Consumer Price Index.

What is it?

It is similar to the RPIX. Both give a measure of the changes in the cost of buying a representative basket of goods and services. But the main difference is that where the RPIX excluded mortgage payments, the CPI will exclude mortgage payments and other housing costs such as repairs, insurance and council tax.

Why the switch?

The main reason is that the CPI is closer to the method used in the rest of the EU and this will make it easier to compare the UK inflation rate with the rest of the EU. This is an important part of judging when would be the right time for Britain to join the euro.

The Government is now using changes in the CPI, instead of the RPIX, as its measure of inflation.



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2.5

Calculating the rate of inflation. Using the CPI the annual rate of inflation is calculated each month: e.g. if the CPI was 500 on 30

September 2003 and 525 on 30 September 2004 then the rate of inflation would be 5% (25 ÷ 500 x 100).

The formula is: (Current index – Last index)/Last index x 100

A note of caution

The rate of inflation measures the rate at which prices are increasing; e.g. a rate of inflation of 3% means that on average prices are rising by

3%. A fall in the rate of inflation does not mean that prices are falling but that they are rising at a slower rate; e.g. if the rate of inflation fell to 2%, this means that prices are now rising at 2% rather than 3%.

Price index at Jan 1

Year 1 100

Price index at 31 Dec

102

Annual rate of inflation

(102 – 100)/100



100 = 2%

Comment



Price level

Year 2 102 106 (106 –102)/102



100= 3.9% increased by 2%



Price level increased by 3.9%



Rate of inflation

Year 3 106

Year 4 107

107

107.96

= 0.9%

= 0.9% increased from 2% to 3.9%






Rate of inflation decreased from

3.9% to 0.9%






Rate of inflation stayed constant



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3 Harmful effects of inflation

3.1 On individuals

(a) It reduces the standard of living of those whose incomes are fixed or which do not rise as fast as the rate of inflation. Their real incomes fall as money loses its purchasing power.

(b) It reduces the disposable incomes of those on low wages because an increase in their money wage arising from inflation may make them liable for income tax and they may al so lose means-tested social benefits. This is called fiscal drag .

(c) It reduces the real value of savings if the interest rate is less than the inflation rate. If the real rate of interest is negative then a saver will lose. The rate of interest quoted on savings is called the nominal rate of interest. The real rate of interest is the nominal rate adjusted for inflation.

Real rate of interest = Nominal rate of interest – rate of inflation e.g. with a nominal rate of 8% and a rate of inflation o f 12%, the real rate would be –4%.

However, even when the purchasing power of savings is falling people still save. Why is this?

• Much of their saving is habitual.

• Much saving is contracted into for long periods of time. It is not easy for savers to get out of insurance or pension fund contracts.

• People need to save if they wish to buy a product which they cannot afford out of one week’s income.

• Many people are ignorant of the effects of inflation on the real value of their savings.

(d) It causes unemployment because:

• wage inflation may force some firms to reduce their labour costs by laying off surplus labour in order to remain competitive.

• reduced competitiveness in domestic and foreign markets may force firms out of business.



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3.2 On firms

(a) It reduces the real value of profits of firms which operate in markets where there is foreign competition. Foreign competitors may produce in economies where inflation is lower. UK firms may not be able to raise their prices sufficiently to cover inflated costs.

(b) It reduces the willingness to invest. Inflation creates uncertainty about future costs and prices – firms uncertain about the future profitability of a new project may cancel any plans to invest. This will also cause unemployment both within the firm and for workers in firms which supply machinery and components.

(c) It encourages inefficiency. Firms which operate in markets where there is little competition may be able to mask inefficiency by raising prices.

3.3 On the economy

(a) The balance of payments may deteriorate . If the rate of inflation is higher than that in other countries then this leads to:

• dearer exports which become less attractive to foreign buyers.

• cheaper imports which become more attractive to domestic buyers.

(b) It reduces economic growth if firms are discouraged from investing (see 3.2 (b) above).

(c) It distorts the balance of taxation. The balance between direct and indirect tax may be distorted because:

• income tax revenue rises automatically with inflating incomes.

• expenditure taxes, e.g. excise duties which are fixed in money terms, tend to fall in real value.

(d) A period of inflation creates an expectation that it will continue and this expectation will ensure that it does, e.g. if worker s expect inflation to be 5% in the coming year, they will demand a 5% increase in pay this year in order to protect the real value of their incomes. If this increase in pay is not matched by an increase in productivity then employers will be faced with inc reased costs and will increase prices, thus causing the very inflation which



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(e) It threatens the use of money in countries where hyper -inflation renders money worthless.

Advantages of inflation

Not everyone suffers from inflation. Some parts of society may actually benefit from it.

(a) Borrowers gain because they have the use of money now when its purchasing power is greater.

(b) Some firms are able to increase prices and profits before they pay out higher wages.

(c) The government finds that people earn more and so pay more income tax.

4 Causes of inflation

Disagreement exists among economists and politicians about the causes.

There are basically two schools of t hought:

(1) Keynesianism, and (2) monetarism.

Keynesianism

Keynesians believe that there are three possible causes of inflation:

(a) Demand–pull inflation which is caused by a desire by citizens, firms or government to spend excessively.

(b) Cost–push inflation costs.

which is caused by increased production

(c) Expectations of inflation

Monetarism

Monetarists believe that inflation is the result of an excessive growth in the money supply .

.



THE UK ECONOMY

4.1

Keynesian demand–pull inflation . This arises when the economy is booming and when aggregate demand is greater than full employment output. Output cannot be increased, prices rise in response to the excess demand.

Demand–pull inflation may occur in particular sectors of the economy even when there is less than full employment in the whole economy, e.g. it may arise when demand exceeds supply in an area of the country such as the south east. House prices, land prices, wages, etc. may rise, which then spreads to other parts of the country.

4.2

Keynesian cost–push inflation . If costs of production increase faster than productivity then this will lead to increases in unit costs. If producers wish to maintain their margin of profit between price and unit cost they have to increase prices. This type of infl ation may occur even when the economy is not at full employment.

Reasons for cost increases

• increases in the cost of raw materials

• increases in the price of energy

• increases in wage rates

• fall in the exchange rate of the £ which increases the prices of imported materials and energy.

4.3

Expectations of inflation . See para. 3.3 (d) above. This is sometimes referred to as a wage–price spiral, in which inflation becomes a permanent feature of the economy.

5 Monetarism

5.1 The quantity theory of money

Monetarism is the belief that increases in the money supply which are greater than increases in output lead to increases in prices. Monetarism was developed in the 1950s by a famous American economist, Milton

Friedman, and is based on the quantity theory of money. The quantity theory of money as developed by Friedman states that:

MV = PQ



29

THE UK ECONOMY where:

M = the money supply

V = the velocity of circulation, i.e. the number of purchases made in a period of time

P = the price level

Q = the quantity of output per period.

Monetarists believe that the velocity of circulation is stable, e.g. in simple terms they think that the number of shopping trips we make is constant from year to year. Any increase in the money supply which is greater than the increase in output causes the price level to rise.

5.2 The money supply

In a modern economy, money consists of:

(a) coins

(b) bank notes

(c) bank deposits, which nowadays are the most important form of money.

Bank deposits are entries in banks bo oks which are created when a customer deposits money or when a bank gives a loan. Bank deposits are transferred between debtors and creditors by cheque, standing order, direct debit or by electronic means (Switch, etc.). There are many different kinds of bank deposit distinguishable by how much notice has to be given before they can be withdrawn.

Increases in the supply of money

There are two major causes:

(a) Bank lending . Interest on bank loans is a major source of income for a bank and banks will therefore lend as much as they prudently can.

(b) Government borrowing from banks . You will find out in Topic

4 that governments often spend more than they take in tax revenue and therefore have to borrow. If they borrow from banks it increases the banks’ ability to lend even more money to their customers. For Higher Economics you do not need to know how this process works.

5.3 Monetarists then believe that excessive bank lending or government borrowing from banks are major causes of inflation. Once inflati on is in



THE UK ECONOMY the economy, as with the Keynesian view, expectations of inflation cause further inflation.

Monetarists believe that demand–pull and cost–push inflation are both symptoms rather than causes of inflation since both result from excessive growth in the money supply.

(a) Demand–pull , they say, results from excessive credit (money supply) being available to consumers and firms which increases their purchasing power.

(b) Cost–push can only be passed on in higher prices if firms have access to cheap excess credit – i.e. they borrow to cover increased costs and pass on the borrowing costs to customers.



31

THE UK ECONOMY

Section 6 is for Higher only

6 The inflation record since 1990

Retail price inflation

Headline inflation (annual % change)

Before 1990, the UK had a poor inflation record compared with the other main industrialised countries. However, since the mid -1990s prices in the UK have been much more stable.

6.1

1990 recession

The economy went into recession between 1990 and 1992 and inflation fell steadily as the crisis in consumer and business confidence reduced aggregate demand. At this time the UK was a member of the Exchange

Rate Mechanism (ERM) and interest rates were kept high to maintain the value of the £ within the ERM. The high interest rates also kept demand low.

6.2

1993–present day

The recovery in demand which started in 1993 was not accompanied by the usual increase in inflation and apart from slight rises in 1995 and

1998 inflation has remained low. Reasons for this include:

(a) pay awards have been low:

• job insecurity has produced a labour force which is more prepared to tolerate low wage rises.



THE UK ECONOMY

• wage bargainers now expect inflation to be low so pay claims are low.

• the bargaining power of trade unions has been reduced – many workers are now casually employed or are employed on individual contracts.

(b) low increase in prices of imported raw materials and energy because global inflation has been low.

(c) firms’ ability to raise prices has been limited by lo w inflation in other countries and because of the intense competition from the

Far East.

(d) tight control of inflation by the government, particularly since

1997 when the control of inflation was handed over to the Bank of

England. The Bank does not need to consider the political disadvantages of raising interest rates and it has not hesitated to raise them when it considered inflationary pressures to be rising.

7 Deflation

Deflation occurs when the general price level is falling. It is tempting to think that if inflation is bad then deflation must be good. This is not so because:

• falling prices usually occur because of falling demand, which makes it harder for businesses to profit and makes redundancies more likely.

• falling prices of shares and houses reduces people’s wealth. This creates a ‘feel bad’ factor which reduces consumer confidence and spending.

• the real value of debts increase, making it harder for borrowers to repay them.



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THE UK ECONOMY

Unemployment

1 Measuring unemployment

1.1 Who is unemployed ? An economist would define an unemployed person as anyone who is able, available and willing to work but cannot obtain a job.

1.2

The claimant count . Traditionally the government has used the claimant count. Each month it publishes the number of peopl e eligible to claim the Job Seekers Allowance (JSA). Unemployment is also expressed as a percentage of the working population (workforce). The workforce consists of employees in work, the self -employed and the unemployed. This method has been criticised as being inaccurate, because:

• frequent changes in the method of calculation have made it difficult to make long-term comparisons.

• some unemployed people are not included because they choose not to register for unemployment benefit.

• some people who are included are working in the ‘black economy’ but fraudulently claim benefit.

• the strict eligibility criteria for JSA prevents some unemployed people from being claimants.

• the change from unemployment benefit payable for 12 months to JSA payable for only 6 months has reduced the number of claimants.

Claimant count unemployment

% of the labour force (seasonally adjusted)



THE UK ECONOMY

1.3

Seasonal adjustment . The claimant count is usually seasonally adjusted . This removes the effects of regular and predictable s easonal fluctuations in unemployment, e.g. building workers in the winter, ski instructors in the summer, etc. When seasonal variations are taken into account then underlying trends can be identified.

1.4

The Labour Force Survey .

Since April 1998, the Government has also published unemployment data, each quarter, based on the Labour Force

Survey. This is a method similar to that used by other countries so it is more suitable for international comparison. The Labour Force Survey surveys a sample of 150,000 people each quarter and counts as unemployed those who were unemployed and who:

• were available to start work in the next two weeks, and

• had actively looked for work in the last four weeks, or

• had found a job and were waiting to start.

The numbers unemployed as counted by the Labour Force Survey are higher than those given by the claimant count and are considered to be more accurate.

Claimant count and LFS measure of unemployment

% of the labour force (seasonally adjusted)

1.5 Why is unemployment measured?

Unemployment is a key indicator of the performance of the economy and is a major social problem.

Government needs to know the scale of the problem before deciding what policy to use to improve it. The problem is not just one of the number of people unemployed. It is also



35

THE UK ECONOMY important for policy makers to know for how long people have been unemployed and to know which age groups, regions and industries are worst affected. Statistics are available for all of these.

2 Types and causes of unemployment

2.1 Cyclical or general . This type of unemployment is associated with recession in the economy when the level of aggregate demand in the economy has fallen. The rate of unemployment is likely to be high.

2.2

Structural . This is associated with the changing structure of an industry.

• New technology

. An industry becoming more mechanised may need fewer workers. Note that in the long term new technology is a creator of jobs. Firms become more competitive and win new markets. New products can be made, again resulting in new markets.

However, in the short run, jobs may be lost in particular firms or industries. The faster that workers and industry can adapt the less will be the problem of this technological unemployment.

• Falling demand

. An industry facing long-term decline in demand for its products because they are obsolete or cannot compete with foreign products will reduce labour.

• Structural unemployment may exist even when the aggregate demand within the economy is high.

3.3 Frictional . This occurs when there are barriers to the free movement

(i.e. friction) of the unemployed into vacancies. This may be caused by

• a lack of knowledge about job opportunities

• occupational immobility , e.g. an unemployed worker not having the required education, experience or skills

• geographical immobility , e.g. an unemployed worker not being able to move to the location of job vacancies – cost of moving, social ties such as children’s schooling, elderly parents to care for

• disincentives to work , e.g. a worker may calculate that because of lost welfare benefits, transport costs and extra direct taxes s/he is no better off working.



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2.4 Seasonal . This occurs in industries such as agriculture, tourism and building where employment fluctuates with the seasons.

3 Full employment, the natural rate of unemployment and NAIRU

Full employment does not mean that everyone who is looking for work has a job. There will always be some people unemployed for structural, frictional or seasonal reasons. Full employment is difficult to define precisely and there have been a number of definitions since the Second

World War. An early definition stated that it would exist if the number of unfilled vacancies equalled the number of unemployed people and it was suggested that full employment would be achieved when there was an unemployment rate of 3%. Today economists and politicians are more cautious about stating a figure and talk more in terms of a concept. They would say that full employment is where unemployment equals the natural rate of unemployment. The natural rate of unemployment is seen as the level of unemployment below which there will be a rise in inflation. Below this level, labour shortages in certain sectors and high demand increase the pressure on wa ges and prices. The remaining unemployment is frictional and structural. The natural rate is sometimes called the NAIRU (the non -accelerating inflation rate of unemployment).

4 Effects of unemployment

4.1 For the individual

Economic effects

• reduced income while major spending commitments continue, e.g. mortgage, credit agreements, etc.

• reduced standard of living

• reduced efficiency as an unemployed worker loses his skill, fitness and motivation.

Social effects

• reduced status – social exclusion from friends because of loss of work and income

• increased health problems both physical and mental, e.g. stress, reduced quality of diet, increased risk of marital break -up.

4.2 For businesses

Negative consequences

• fall in demand for goods and services – fall in revenue and profits

• knock-on effect on suppliers (multiplier effect).



37

THE UK ECONOMY

Positive consequences

• bigger pool of labour available

• less pressure to pay higher wages

• less risk of industrial action from employees because of fear of jo b loss.

4.3

For the economy

Economic costs

• lost output – real GDP will fall – economy will be operating well within its production possibility curve

• multiplier effect of reduced demand – reduced spending of the unemployed or those fearing unemployme nt – affects jobs of others

• reduced taxation revenue for the Government – fall in revenue from income tax and taxes on consumer spending; fall in corporation tax on company profits

• increased burden on taxpayers to fund benefits and training measures.

Social effects

• increased crime

• civil unrest

• increased burden on healthcare system.

5 All types of unemployment have been in evidence in recent years

5.1 Cyclical . During the recession of 1990 to 1992 there was a fall in aggregate demand.

5.2 Structural . There has been a continued decline in employment in manufacturing industries for the following reasons:

• inability of some industries to compete with foreign firms particularly those in the ‘tiger economies’, e.g. China, Hong Kong, Singapore,

Taiwan and Korea

• rapid mechanisation

• privatisation of nationalised industries led to large -scale job reductions

• after privatisation, industries continued to shed labour in large numbers, e.g. BT.

5.3 Frictional . There is a lack of flexibility in t he labour market – for the causes, see para. 2.3.



THE UK ECONOMY

Section 6 is for Higher only

6 Trends in unemployment

6.1 Total unemployment has fallen

UK claimant count unemployment

Since 1993 unemployment in the UK has been on a downward trend. A number of factors can account for this:

• sustained economic growth

• a slowdown in the numbers of school leavers entering the labour market

• more students staying on in further and higher education

• the success of the Government’s ‘Welfare to Work’ programme.



39

THE UK ECONOMY

6.2 Regional differences in unemployment remain

Regional unemployment in the UK

% of the labour force

North-East London Wales North West UK Total Eastern SE

Scotlan d N. Ire Yorks W. Mid E. Mid SW

Labour Force Survey, unemployment rate (%) – June to August 2001

For the UK those regions closest to London and the south -east continue to have the lowest rates of unemployment whereas those such as

Scotland, Northern Ireland and the north -east of England have the highest. The growth in service jobs in the prosperous south and the decline in primary and manufacturing jobs in other regions account for these differences.

Within Scotland there are also wide differences. The Edinburgh area with its growing number of service jobs and its success in attracting electronics businesses is prosperous. The oil industry explains the lower level of unemployment in the north-east. Higher rates of unemployment exist in west-central Scotland because of the decline in manufacturing jobs and in the Highlands and islands because of their remoteness.

However rates of unemployment have also been falling in these areas.

6.3 The pattern of employment has changed . The numbers employed in the primary and secondary sectors have continued to fal l whilst the number employed in the tertiary sector have risen. Most of these jobs were full time and taken by men. An increasing number of new jobs in services are part time, temporary and are taken up by women. These changes help to explain why men accou nt for a growing proportion of the unemployed.



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Topic 3: The Role of Government in the Economy

Economic Systems

1 The basic economic problem

1.1 All nations face the problem of scarcity, i.e. they have insufficient resources to produce all the goods an d services which their citizens need and want. Three basic questions have to be addressed:

• What goods and services will be produced?

• How will these goods and services be produced?

This means who will do the production and which methods of productio n will be used.

• To whom will the goods and services be distributed?

This means who will consume the goods and services after they been produced – and how will it be decided who receives them.

1.2 To address these questions a nation needs an economic sy stem. There are three different economic systems: the command or planned economy, the market economy and the mixed economy. Each has different ways of allocating resources to producers and of distributing goods and services to consumers.

2 The command economy

2.1 The economies of various communist countries such as China and the

Soviet Union were command economies. During the Second World War, the UK economy was a command economy as government took charge of production decisions.

2.2 The main features of a command economy are:

• Resources are owned or controlled by the Government.

• Government plans what will be produced and allocates resources accordingly.

• Producers have limited freedom to change methods of production or to develop new products.

• Government controls prices.

• No private profit.

• Little competition.



41

THE UK ECONOMY

2.3 What to produce and how to produce are decided by the Government.

To whom goods are distributed is also strongly influenced by the

Government because incomes and prices are controlle d.

2.4 Problems of a command economy include:

• Inefficient allocation of resources because of the Government’s failure to plan accurately for society’s wants – leading to shortages of some products and surpluses of others.

• Control of prices makes it impossible to judge the real wants of consumers.

• Inefficient production resulting from lack of profit motive and lack of competition.

• Limited freedom of choice for consumers.

2.5 Possible advantages of a command economy may include:

• Basic necessities are made available to everyone at a price they can afford.

• A fairer distribution of income and wealth.

3 The market economy

3.1 The main features of a market economy are:

• Private individuals own resources.

• Producers are free to produce what they wish.

• Consumers have consumer sovereignty (literally meaning the consumer is king) and rule the market, i.e. the freedom of consumers to decide what to buy influences what producers produce.

• Decisions are made on the basis of self-interest. Producers aim to maximise profit. Consumers aim to maximise value for money.

• Competition exists between producers and between consumers.

• Resources are allocated by the price mechanism . Price acts as a signal to producers. Products which consumers demand will ris e in price, which in turn will raise profits, thus encouraging producers to produce them. Producers will need more resources. They will attract them by offering higher incomes to those who own them. Falling demand for products will result in lower prices, falling profits and lower rewards for resources so that producers will be encouraged to move to where rewards are greater.



THE UK ECONOMY

3.2 What to produce is decided by consumers.

How to produce is decided by producers using the most efficient methods of production in order to keep down cost so that they can compete and maximise profit.

To whom products is distributed is decided by the buying power of those consumers who earn the highest incomes from the resources which they own.

3.3 Advantages of a market economy may include:

• Efficient allocation of resources, i.e. resources are used to produce those goods and services most wanted by consumers.

• The clearing of markets of surpluses or shortages by the price mechanism.

• Technical efficiency in production as producers strive to keep down costs.

• Freedom of choice for consumers.

3.4 Disadvantages of a free-market economy may include:

• Failure of producers to produce public goods, i.e. goods and services whose benefits are shared by the whole community, e.g. defence, law and order.

• Failure of producers to produce sufficient merit goods, e.g. healthcare and education. They may be provided for richer consumers but not for those who cannot afford to pay.

• The production of undesirable goods, e.g. addictive dru gs.

• Production methods which take no account of external costs, e.g. pollution.

• The development of monopolies, oligopolies and restrictive practices which eliminate the benefits of competition.

• Wide inequalities in income and wealth.

For more detail on this, see the section on Market Failure in Topic 3.



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THE UK ECONOMY

4 The mixed economy

4.1

There has long been a debate about the efficiency of the allocation of resources in the free-market system compared with the command economy.

4.2 From 1945 to 1979, the UK saw a substantial increase in Government intervention, with many industries being nationalised (e.g. steel, coal, rail). During the 1980s, there was a reversal of this policy, and privatisation returned most of these industries to the private sector.

4.3 By the early 1990s, it was apparent that extreme Government intervention as practised by the planned economies of the former communist countries in Eastern Europe had been a failure in terms of increasing living standards at the same rate as in the west.

4.4 Despite the move towards free-market-type economies, there is still a need for government intervention. This is because of what is known as market failure.

4.5 Summary of the role of Government in the UK mixed economy:

•

Providing public goods and services – defence, law and order, roads – which the private sector could not provide.

• Providing merit goods and services – education, healthcare, art galleries – which the private sector does not provide in sufficient quantity.

• Controlling and regulating the private sector – protecting workers and consumers – health and safety, dangerous products, minimum wage and employment conditions, monopolies.

•

Dealing with market failure .

• Controlling overall economic performance – unemployment, inflation, economic growth, balance of payments imbalance.

•

Redistributing income – tax and benefits, regional policy.



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Increasing the Role of the Private Sector

1 Introduction

Since 1979, there has been a major shift in the provision of public services. Many industries have been privatised whilst other services, although still financed by Government, are contracted out for private firms to provide. Government has also reduced much of the red tape which limited competition in the private sector – a policy called deregulation .

2 Privatisation

This is the sale of assets owned by the public sector. This includes selling nationalised industries (e.g. steel, coal, rail) and assets of central government departments (e.g. land, houses) and local government (e.g. land, water, council houses).

2.1

Methods of privatisation

•

Stock market flotatio n – shares were advertised for sale in national newspapers at a fixed price. Subscribers bid for shares at that price and the government then allocated the shares, e.g. British Ai rways,

British Telecom.

• Sale by tender – minimum price was set and prospective buyers bid for shares at or above that price. The shares then went to the highest bidders, e.g. Britoil.

• Private sale – asset is sold to a single buyer, e.g. Rover sold to

British Aerospace (since sold to BMW); council houses sold to tenants.

3 Contracting-out

This is where a service previously run by civil servants or local government employees is contracted out to the private firm which offers to provide it at the lowest cost, e.g. school cleaning, school meals, refuse collection. This process is also called compulsory competitive tendering.

4 Private finance initiative (PFI)

This is a step further than contracting out. Private -sector companies are invited to pay for and provide capital investment projects such as school, prison and hospital buildings, rail links



45

THE UK ECONOMY

(e.g. Channel Tunnel Rail Link); bridges (e.g. Skye Bridge). The

Government then takes out a long lease, e.g. for 25 years and pays for the service over that time out of tax revenue.

5 Deregulation

Deregulation involves the removing of government regulations which have been barriers to competition, e.g. removing BT’s sole right to provide the telecommunication service; removing opticians’ sole right to supply spectacles; removing bus route licences which allowed only one company to service a particular route.

6 Aims of privatisation

6.1 To improve efficiency . Government’s intention is to improve both:

• technical efficiency , where competition is an incentive to cut unit costs and improve quality

• allocative efficiency , where resources are more likely to be allocated to produce the goods and services which consumers most want to buy and which will therefore create the highest profit.

6.2 To reduce Government interference in the market

• to reduce interference by government ministers in the making of commercial decisions by firms. This frequently happened for political reasons, e.g. a nationalised firm (e.g. electricity) not being allowed to raise prices or close down a loss-making plant, or being forced to open up a plant in a high -unemployment area even when it was not the most efficient location (e.g. steel).

• to allow industries to diversify into new and profitable lines of business, e.g. nationalised industries were restricted to a narrow range of activities; now they are free to pursue any profitable activity, e.g. electricity companies are now involved in supplying gas, telecommunication services, etc.

6.3 To reduce the power of trade unions in the public sector

• Nationalised industries usually had a monopoly of the service they provided. Trade unions had great power because industrial action had a large impact on consumers. By breaking up



THE UK ECONOMY nationalised industries and introducing competition there were alternative suppliers to whom consumers could go in the event of industrial action.

• Firms no longer owned by Government could not submit to wage demands and expect Government to subsidise large pay awards.

6.4 To reduce Government borrowing

• Privatised firms which make losses can no longer borrow from

Government.

• Privatised firms now have to raise new capital on the private capital market and not through Government borrowing.

• With a private finance initiative (PFI), companies borrow the cash to build and run new schools, hospitals, etc.

6 .

5 Political motive

Privatisation has been a very popular policy with voters and, once started, Governments had encouragement to continue.

7 Problems

7.1 Inefficiency

Some privatised companies have had to operate in highly competitive markets, e.g. British Airways and British Steel and have had to improve their efficiency. However, a number of those industries which have been privatised are natural monopolies (a natural monopoly is where the most efficient market structure is a monopoly – e.g. in domestic water supply where it would be a waste of resources for a second supplier to build a second network of pipes). The incentive to improve efficiency has not been so been great in those, even although the

Government has appointed regulators such as Ofgem, Ofwat and Oftel

(see 8.1). Critics argue that the regulators have not been tough enough in controlling the prices and quality of service of the public utilities.

7.2 Excess profits

Profitability has varied enormously, but those firms which have a high degree of monopoly power have made very large profits, e.g. British

Gas and BT at the expense of consumers.



47

THE UK ECONOMY

Critics of PFIs argue that although they are portrayed as using private money, taxpayers still have to pay. They will end up paying more because private capital is more expensive to borrow than public capital and they will have to pay for a longer period.

7.3 Lost jobs and poorer working conditions

• There have been large redundancies in some industries as they have sought to improve efficiency, e.g. British Steel and British Airways; although supporters of privatisation would argue that such industries were over-manned.

• Many workers in firms providing contracted-out services now have poorer wages, poorer working conditions and less job security.

7.4

Reduced services

Cross-subsidisation was common in nationalised industries for social reasons. For example, on the railways a loss -making service was subsidised by profitable services. Privati sation may harm consumers if they have to pay the full cost of the service or if the service is withdrawn because it is non-profit making. However, Government has ensured the continued provision of many socially necessary services by subsidising them.

7.5 Widening of share ownership

An aim of the privatisation policy was to encourage a larger percentage of the population to become share owners. This has occurred, but not by as much as Governments would have hoped for because:

• Many who bought shares sold them quickly (mainly to financial institutions) to profit from the rapid rise in their price.

• Many shareholders hold the shares of only one privatised industry.

• Most shares are still owned by large financial institutions such as insurance companies and pension funds.

7.6 Assets sold too cheaply

Critics have claimed that many nationalised industries were sold too cheaply and much potential revenue for the Government was lost.

Government argued that they had to be offered at a low price to ensure their sale.



THE UK ECONOMY

8 Government control of privatised industries

8.1 Privatised enterprises which operate in competitive markets need no regulation, e.g. British Steel has to compete with international producers in the world market.

Privatised enterprises which operate in markets where there is insufficient competition are regulated. Regulatory agencies have been set up to oversee certain industries e.g.:

• Oftel (telecommunications)

• Ofgem (gas and electricity markets)

• Ofwat (water).

8.2

Objectives of regulation

• to protect consumers from exploitation

• to encourage efficiency and innovation

• to promote competition.

8.3

Forms of regulation

•

Price regulation – regulator fixes a maximum price – usually RPI less a certain percentage.

• ‘ Yardstick competition ’, e.g. the electricity and water industries have been split up geographically with different companies in different parts of the country. The regulators then compare the performance of the different companies.



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Public Expenditure and Finance in the UK Economy

1 Public-sector expenditure

1.1

Public-sector expenditure is the name given to spending by central government, local government and public corporations, e.g. the Post

Office, the BBC. Plans for public-sector spending are published annually along with the Budget. These plans show intended spending for the coming 3 years.

1.2

Types of public-sector spending

•

Capital spending . This helps to create productive capacity, e.g. hospitals, urban renewal and transport infrastructure.

• Current spending . This covers day-to-day running costs of government, e.g. the pay of public -sector workers.

•

Transfer payments . A transfer payment is defined as a payment to an individual or firm for which there is no economic benefit given in return, e.g. pensions, unemployment benefit, child benefit, grants and subsidies. They are called transfer payments because money is transferred from taxpayers to those who qualify for benefit.

The distinction between types of spending is important because capital and current spending diverts resources from the private sector; whereas transfer payments do not absorb resources but redistribute income and spending power within the private sector.

Most of the Government’s capital and current expenditure is on public and merit goods and services.

1.3 A public good or service is one which benefits everyone in society, e.g. defence, street-lighting. A public good cannot be provided by the private sector because of the difficulty in getting all its consumers to pay. Government, therefore, has to provide public goods and raise the required revenue from general taxation.

1.4 Merit goods or services, e.g. healthcare, education, are considered to be socially desirable but would be under produced if left to private enterprise. Merit goods or services are given to those people who merit

(i.e. need) them, either free or at reduced prices. These are paid for out of taxation and in some cases, e.g. medical prescriptions, by charging consumers a proportion of the price.



THE UK ECONOMY

1.5

Trends in public-sector expenditure

Changing total

In recent years there has been an increase in Government expenditure in the economy. This has been due mainly to increases in spending on health, education and transport.

Changing pattern

Increases in spending on health and education have been proportionately greater than on other programmes. Defence spending has fallen because of the end of the ‘cold war’, which has given us a

‘peace dividend’.

Social security spending has increased because the ageing popula tion has led to more spending on retirement pension.

However, there have been reductions in areas such housing where – as part of its privatisation policy – government has limited its spending on building new council houses. Spending on support for indus try has also become less important.

There is strong debate among economists and politicians about the merits of public-sector expenditure.

1.6

Case for reducing growth in public spending

• Income tax can be reduced which will increase incentives and increase consumers’ freedom to choose how to spend their incomes.

• Government borrowing can be reduced.

• Resources can be released for use by the private sector. It is thought by some that the private sector uses resources more efficiently.

1.7

Case against cuts in growth of public spending

• Most public-sector spending is on UK-produced output which creates employment in the UK. If given back to consumers by reducing tax, it may be spent on imports.

• Capital spending is the easiest for government to cut but this reduces the country’s infrastructure, which in turn reduces the efficiency of the economy, e.g. there have been major cuts in recent years in housing.

• Resources released from the public sector are not automatically taken up by the private sector. They may remain unemployed.



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• Lower-income groups are the most dependent on public spending, not only on benefits but also on services such as housing and public transport.

2 Taxation

2.1

Types of taxation

Direct taxes

Direct taxes are defined as those taxes which are taken directly from individuals and firms. They are levied by the Inland Revenue department. They are mainly taxes on income and wealth, e.g.:

• income tax

• national insurance contributions – although not called a tax, in fact it is

• corporation tax – levied on company profits

• council tax – levied on the value of a householder’s house

• capital gains tax – levied on the increase in value of assets

• inheritance tax – levied on a deceased person’s estate

• stamp duties

– levied on the change of ownership of houses and land.

Indirect taxes government passes on the burden of the tax, usually to a customer.

These are collected by the Customs and Excise Department. They include:

Indirect taxes are levied indirectly, i.e. the payer of the tax to

• Value Added Tax (VAT) – levied on a wide range of goods and services. Some goods, e.g. children’s clothes, books and basic foodstuffs are zero-rated

• customs duties – taxes on imports

• excise duties – taxes on petrol, tobacco and alcohol

• petrol revenue tax – tax on North Sea oil companies

• motor vehicle duties .



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2.2

What makes a good tax?

Adam Smith, the famous eighteenth-century Scottish economist laid down four principles (or ‘canons’, as he called them) for a good tax.

(a) Equity . Taxes should relate to the taxpayer’s ability to pay.

(b) Efficiency . Taxes should be reasonably inexpensive to collect, i.e. the cost of collection should form a small percentage of the revenue collected and they should not have negative side -effects such as reducing work incentives for individuals.

(c) Certainty . The taxpayer should be clearly aware how much is due, and when and where to pay.

(d) Convenience . Taxes should be payable at a time and place that suits the taxpayer.

Not all taxes levied in the UK adhere to these principles.

2.3

Progressive and regressive taxes

A progressive tax is one which takes account of people’s ability to pay, i.e. it follows Smith’s principle of equity. A progressive tax takes a larger percentage of income as income rises. Most direct taxes are of this type.

A regressive tax takes no account of people’s ability to pay. Lower income earners pay a higher percentage of their income in tax. Most indirect taxes are regressive, e.g. duties on alcohol, petrol, road tax are fixed amounts of money which are the same for everybody. VAT, although an indirect tax, takes some account of ability to pay in that some essential items such as food, children’s clothes and shoes, which account for a large proportion of a low inco me earner’s spending, are zero rated and household fuel is rated at 5%. Nevertheless VAT is a regressive tax.



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2.4

Trends in taxation

Cuts in business taxes, e.g. corporation tax and business rates

The aim has been to allow firms to earn higher profit s and so encourage investment. The UK now has lower business taxes than most other

European countries, which helps to attract inward investment.

Shift from direct to indirect tax

In the 1980s Conservative Governments started to restructure taxation by shifting the balance away from direct taxation towards indirect taxation and this policy was continued in the 1990s. The restructuring was done by simplifying and reducing rates of income tax. The

Conservatives believed that lowering rates of income tax wou ld encourage enterprise and effort. The top rate has been cut from 83% in

1979 to 40%; standard rate from 33% to 22%. There is also now a starting rate of 10%. The share of income tax in total tax revenue has fallen from 45% to 25%. The loss in revenue fro m income tax cuts was largely recouped from VAT which has been raised and extended to a wider range of goods and services. Excise duties on tobacco, alcohol and motoring have been increased by more than inflation. The effect of the restructuring has been to tilt the balance of taxation away from earning to spending and to make the tax system more regressive. A further effect has been a widening of the gap between rich and poor.

The Labour Government elected in 1997 gave a promise that it would not raise income tax nor extend VAT. However, it has started to narrow the rich–poor gap by a reform of other taxes.

2.5

Case for cuts in income tax

•

Tax revenue may increase.

High rates of income tax encourage people to exploit every possible loophole to avoid tax and they encourage some people to break the law in order to evade tax.

Cutting rates may remove this evasion.

•

Incentives are increased.

If marginal rates of tax are reduced then people will be able to keep more of any additional income they earn.

This may act as an incentive to work harder or to seek promotion.

Lower tax rates may also encourage some of the voluntary unemployed to work.

As people work harder and earn more, the tax revenue in total may rise.



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The potential revenue from income tax cuts can be illustrated by the

Laffer curve (Laffer is a US economist). Since no revenue can be expected from tax rates of 0%, the curve of tax revenue rises as tax rates rise but eventually falls because of disincentives, evasion and avoidance, until at 100% rates tax revenue would return to zero. The difficulty for a Government is knowing which tax rate would yield the highest tax revenue.

Tax revenue

2.6

Case against cuts in income tax

•

Some economists argue that tax revenue may not increase higher disposable income from working the same or fewer hours may encourage people to take more leisure time.

. A

•

Tax rate

The demand side of the economy may be over stimulated leads to inflation.

. This

•

Inequalities are likely to widen . Since income tax is progressive, cuts are likely to favour those on higher incomes while those on low incomes who are not liable to income tax will gain no benefit. If, as has been the case, government switches to more taxes on expenditure, which tend to be regressive, then those on low incomes are further disadvantaged.

3 Public Sector Net Cash Requirement (PSNCR)

3.1

PSNCR .

The PSNCR is defined as the borrowing of the public sector, i.e. central government, local authorities and public corporations. There is a need for the public sector to borrow if its expenditure is greater than its income. The main factor in this is usually a central government budget deficit. The PSNCR is measured in £ billion and as a percentage of GDP. It is financed by selling bonds, gilt -edged securities and



55

THE UK ECONOMY treasury bills to financial institutions and to citizens. In some years the

PSNCR may be negative. In this case the government is running a budget surplus and is then able to repay debt.

3.2

The Budget . A Government must plan what it wants to spend a nd how it is going to finance its expenditure. This plan is usually done once a year and is presented to parliament as the Budget . However, the Budget may be used for purposes other than just a financial plan. This is covered in Topic 4 Government Economic Policies .

Budget deficit

If central government income is less than central government spending, this is called a budget deficit.

You should note that the Budget is as much a political exercise as an instrument of economic policy. For example, in the run-up to an election measures in the Budget may be taken to win political support which may be against the interest of the economy at that time.

3.3

National debt .

The national debt is the total amount of accumulated debt, i.e. the total amount which th e public sector owes to those who have loaned it money. If in one year there is a PSNCR, then the national debt will increase. A budget surplus will reduce the national debt.

3.4

Why government needs to control the PSNCR .

A high PSNCR may cause the following problems:

• ‘Crowding out’ – high Government borrowing may starve the private sector of funds for investment.

• Interest rates may have to rise

to encourage lenders to lend to

Government. The UK Government usually has little difficulty in borrowing money because lenders have confidence in its ability to repay. However, when the borrowing requirement is large it may have to offer higher rates of interest to attract extra funds. This also increases the cost of borrowing for the private sector.

• Inflation . Monetarists believe that if Government borrowing is financed by borrowing from banks then the money supply increases and causes inflation.



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• National Debt is increased

– this leads to higher repayments of debt interest in the future which have to be f inanced by higher taxes or reductions in other spending programmes.

• EMU

. A condition for membership of Economic and Monetary

Union (EMU) in Europe is that in any year the PSNCR should be no more than 3% of GDP and the national debt should be no more than

40% of GDP. Government therefore has to try to stick to these requirements.

3.5

Difficulties in controlling Government borrowing . It is difficult for governments to control their borrowing because of the difficulty in predicting the economic cycle. The a mount of money the government spends and receives from taxation fluctuates with the economic cycle.

In periods of economic growth and rising employment spending on benefits decreases while tax revenues increase from higher incomes, consumer spending and business profits. The opposite happens during a recession!

3.6

UK trends

The recession of 1990–2 had increased the PSNCR. Tax revenues fell but public expenditure on unemployment benefits and social security payments increased. The government could have increased tax rates to reduce the Public Sector Borrowing Requirement (PSBR) but the economy was too weak to stand this.



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From 1994 to 1997, the PSBR fell. As the economy recovered from recession, tax revenues increased as GDP increased a nd government felt able to increase taxes.

The new Labour Government of 1997 set a tough target for government borrowing and intended to achieve it by maintaining strict control of public-sector spending, and raising some taxes (although it had a commitment not to raise income tax or extend VAT). It restored the

‘golden rule’ of fiscal policy.

Golden Rule of Fiscal Policy

The golden rule is that in the long run government borrowing should only be allowed to finance capital expenditure rather tha n current expenditure. The thinking is that capital spending, such as new hospitals and roads, will benefit present and future generations and should be paid for by those who benefit now and in the future.

Current spending, such as teachers’ salaries, school books, etc. should be paid for now by taxing the generation who benefit from this spending. The Chancellor has modified this by stating that borrowing to fund current spending should be neutral over the economic cycle, i.e. it may need to borrow dur ing years of recession but that this should be repaid out of budget surpluses in years of growth.

The 1997 and 1998 Budgets were both tight, i.e. taxes were higher than spending. The public finances improved to the extent that instead of having to borrow the Government was able to repay debt. In 1999 and

2000 public finances continued to improve and the Chancellor was able to reduce tax receipts in the Budget of 1999 without having to borrow.

Since 2001 public borrowing has grown as the economy and t ax revenues have not grown as fast as the Chancellor predicted and because of very large increases in capital spending in health and education. Note that although the figures are very large, they are a small percentage of GDP, e.g. the national debt of the UK will be 35% of GDP in 2005, compared with 50% in the USA and Germany and 80% in Japan.



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Government Economic Objectives

1 Introduction

The role of government in a mixed economy is to:

• provide goods and services which cannot be provided by the pri vate sector

• regulate the private sector in order to protect the consumer, employee and the environment

• set objectives of economic policy and choose instruments of policy.

2 Objectives

Government may set itself microeconomic objectives and macroeconomic objectives. Microeconomic objectives relate to the performance of a part of the economy, whereas macroeconomic objectives are concerned with the performance of the economy as a whole. Different governments will set themselves different objectives and it does not follow that all governments will aim for all the objectives given below.

2.1

Macroeconomic objectives

• to achieve economic growth

• to achieve low and stable inflation

• to reduce unemployment

• to keep the current account of the balance of payments in balance.

2.2

Microeconomic objectives

• to prevent market failure

• to distribute income and wealth more fairly

• to reduce regional disparities.

3 Policies

To achieve its objectives, a government has a number of different policy instruments available and it is likely to use a number of them at the same time. These include:

• fiscal policy

• monetary policy



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• supply-side policies

• exchange rate policy*

• external trade policy*

• regional policy

* Covered in the notes for Unit 3, Topic 1, International Trade and

Payments .

4 Problems of reconciling conflicting objectives

Governments face a number of problems in trying to achieve their economic objectives.

These include:

4.1 Conflicting advice . Governments depend on economists for advice and since economics is not an exact science they may receive different suggestions for solving a particular problem. You have already seen the difference in views between Keynesians and monetarists.

4.2 Inadequate information . Government economists and politicians depend on accurate information about the size and extent of a problem.

This information depends on the accuracy and methods of gathering statistics. Information may be inaccurate and out of date. Government also depends on forecasts which are often inaccurate.

4.3 Time lags . It takes time for government to recognise the existence of a problem, to implement a policy and for consumers or producers to react to it. Meanwhile economic circumstances may have changed, so that the policy makes the problem worse, e.g. Government may believe that the economy is in for a period of inflation and so introduce an anti -inflation policy but in the meantime demand may have been falling anyway so that the policy drives the economy further into recessi on.

4.4 Policy constraints . The UK is a member of the European Union (EU).

This means that there are certain policies which it cannot use, e.g. introducing restrictions on trade, removing VAT from certain products, and if the UK joins the ‘euro’ it will have to accept a currency interest rate which is set by the European Central Bank.



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4.5 Political pressures . In the run-up to an election, governments are unlikely to introduce harsh economic policies even if they may be necessary.

4.6 Conflict between policy instruments . A policy to solve one problem may cause another, e.g. to improve the balance of payments, the

Government may raise interest rates in order to reduce consumer demand for imports, but this in turn may increase the exchange rate. A higher exchange rate then raises the price of exports and reduces the price of imports, which is harmful to the balance of payments.

Similarly, in trying to boost economic growth, the Government may take steps to increase demand but this may lead to inflation.

You need to know the policy instruments which a government may use as well as how they are used in trying to reach objectives. In the following topic you will find the main policy instruments which governments use, followed by how particular objectives may be achieved.



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Topic 4: Government Economic Policies

This topic is for Higher only

Demand and Supply Sides of the Economy

The demand side of the economy

This refers to aggregate demand for goods and services produced in the UK.

You will remember that this consists of consumer spending, investment spending, government spending and the spending by foreign buyers on UK exports. Spending on imports is subtracted. The shorthand for all of this is

C + I + G + (X – M). The level of demand in the economy has an important influence on its performance, i.e. if there is too much demand then inflation ensues; too little then there is cyclical unemployment. Government can change the level of aggregate demand by:

• fiscal policy, or

• monetary policy.

These are called demand-side policies.

The supply side of the economy

This refers to that part of the economy which produces goods and services.

The performance of the economy is in effect limited by its productive potential, i.e. its production possibility frontier. This in turn is affected by the quantity of resources available and the efficiency of those resources.

Government can influence the supply side by what are called supply -side policies.

Fiscal Policy

1 Introduction

Fiscal policy is when Government changes its spending or taxation in order to influence the performance of the national economy. Fiscal policy aims to change the level of aggregate demand.



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2 The Budget

2.1 You saw in the last topic that a government must plan what it wants to spend and how it is going to finance its expenditure. This plan is usually done once a year and is presented to parliament as the Budget .

2.2 As well as financial planning the Budget may be used:

• to alter tax rates or introduce new taxes

• to achieve macroeconomic targets such as growth, employment, inflation

• to achieve microeconomic targets by changing the economic behaviour of certain groups, e.g. taxing ‘alcopops’ at a high rate.

3 Fiscal policy and macroeconomic objectives

3.1 If a Government decides to use fiscal policy to influence demand in the economy, it can choose either to change its expenditure or taxes.

3.2 Remember from your previous notes that:

Aggregate demand = C + I + G + (X – M)

4 Unemployment

4.1 If there is high unemployment caused by insufficient demand then government could increase demand:

(a) by spending more itself (G), e.g. capital spending on new hospitals, roads, etc. or current spending, e.g. employing more nurses, teachers, etc. This extra spending would be an inje ction into the economy.

(b) by reducing taxation, e.g. reducing corporation tax allows firms to keep more of their profits which they may use for investment (I), or reducing income tax allows individuals more after -tax income to spend (C). The Government would be reducing a withdrawal.



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4.2 Whether government spending is raised or taxation is cut, the increase in the injection or the reduction in the withdrawal will have a multiplier effect on national income and employment.

4.3 If either of the above fiscal policies were adopted then the Budget would be in deficit and the PSNCR would rise.

5 Inflation

5.1 If there is inflation caused by too much aggregate demand then government could cut demand by:

(a) cutting its own spending (G).

(b) increasing taxation to cut either consumer spending (C) or firms’ spending on capital goods (I).

5.2 If either of the above fiscal policies were adopted then the Budget would be in surplus and debt could be repaid.

6 Problems with fiscal policy

6.1

Conflicting objectives . Governments aim for:

• full employment

• economic growth

• balance in the current account of the balance of payments

• low inflation.

A fiscal policy which raises aggregate demand in order to increase employment and encourage economic growth co uld damage other aims; it could:

(a) worsen the balance of payments if consumers and businesses spend their extra disposable incomes on imported consumer goods, machinery and raw materials

(b) cause inflation if demand increased faster than supply or b y too much.

Fiscal policy to reduce demand in order to lower inflation or correct a balance of payments deficit could:

(a) cause unemployment, or

(b) lower economic growth.



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6.2

Forecasting the required changes in demand

(a) Data on which plans have to be made are not reliable because collecting information on large totals such as national income or consumption is subject to time lags and errors.

(b) The multiplier effect of increased G or of reduced T is difficult to predict.

(c) When the policy will take effect is difficult to estimate.

6.3

Fine tuning

Fiscal policy is therefore not a precise policy instrument. During the

1930s, unemployment was so great that the bluntness of fiscal policy did not really matter. In the post -war economy, shortfalls or excesses in demand have been much smaller and fiscal policy frequently missed the target. Either too little demand was injected into the economy so that unemployment remained or too much demand was injected and there was a problem with inflation. It was difficult to fine-tune the economy.

7 Changing importance of fiscal policy

7.1 The use of fiscal policy to control demand, employment and prices was unheard of until the 1930s when the famous economist, Keynes, explained how it could be used. In the post-war period until the late

1970s fiscal policy was the main policy used to control aggregate demand in the economy. Monetary policy was secondary to fiscal policy. The control of bank credit and the rate of interest were used to fine-tune demand between budgets.

7.2 The high rates of inflation and rising unemployment in the 1970s questioned the effectiveness of fiscal policy and when the

Conservatives came to power in 1979 they changed the policy.

Monetary policy was to become the main weapon and fisca l policy was not to be used to manipulate demand in the economy. In fact, the aim was to balance the Budget and eliminate the PSNCR. The Labour

Government elected in 1997 continued this policy. The Chancellor has no intention of using fiscal policy to con trol demand but to use it in support of monetary policy by curbing the Budget deficit. Remember that a Budget deficit and high PSNCR is inflationary and also puts upward pressure on interest rates. (See also your notes on Monetary

Policy.)



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The rest of these notes are for Higher only

Monetary Policy

1 Introduction

Monetary policy is the policy which uses interest rates or controls the supply of money as a means of achieving a government’s macroeconomic objectives.

2 The Bank of England

The Bank of England is the UK’s central bank. It has certain key functions:

2.1

The Government’s bank

• It handles the enormous amounts of money in the government’s accounts, e.g. the social security and defence accounts.

• It borrows money for the government from private individuals and financial institutions and repays loans and interest to lenders when they are due, i.e. it manages the national debt. Note that the government does not borrow from the Bank.

• It is responsible for the issue of notes and coins into th e UK economy.

2.2 It is responsible for carrying out monetary policy

• The Government sets a target for inflation and the Monetary Policy

Committee of the Bank has to change interest rates to meet that target.

• It acts as the Government’s agent in the foreign currency market buying and selling foreign currency as well as intervening to manage the exchange rate of the £.

2.3

It is the bankers’ bank

• All commercial banks hold accounts at the Bank of England. If one bank owes another bank money, a transf er between their accounts at the Bank settles the debt.

• It is the ‘lender of last resort’ – the Bank assists the banking system when it is short of cash.

• It inspects and controls banks in order to protect their customers.



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3 Monetarism

3.1 You will remember from Topic 2 on inflation that monetarists believe that if the money supply grows faster than output then the result is inflation. In their view control of the money supply is vital for controlling inflation and this control must be aimed at

(a) bank lending, or at

(b) borrowing from banks, or at

(c) government borrowing from banks.

4

Controlling banks’ ability to lend (i.e. the supply of money)

This would involve intervention by the Bank of England to control bank lending. Because of the difficulties involved in monitoring and controlling the activities of banks, many of which are foreign, this policy is no longer used.

5 Controlling borrowing from banks (i.e. the demand for money)

Changing the rate of interest can influence the demand fo r loans by firms and households. Increasing the rate of interest will reduce demand for credit; lowering the interest rate will make borrowing cheaper.

6 Controlling government borrowing from banks

Government can reduce its demand for loans by reducing the public sector net cash requirement (PSNCR). To reduce the PSNCR it needs to reduce public sector spending or raise taxation.

7 Monetary policy and government objectives

7.1 Inflation . If a government wanted to reduce demand in an attempt to lower inflationary pressures it would run a tight monetary policy, i.e. raise interest rates or reduce the money supply.

Raising interest rates would also increase the exchange rate. A higher exchange rate can reduce inflation in three ways:

• It lowers the price of imported finished goods.

• It lowers the price of imported raw materials.

• It puts pressure on domestic firms to lower their costs to remain competitive.



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7.2 Economic growth and employment . If a government wanted to boost demand in the economy, say, in times of a recession, it could lower interest rates. Lower interest rates also lowers the exchange rate which in turn makes exports cheaper. Increased demand for exports increases employment.

7.3 Balance-of-payments deficit . An increase in interest rates will cut aggregate demand including the demand for imports.

8 Changing importance of monetary policy: the Monetary Policy

Committee

Since 1979 monetary policy has been the main policy used to control inflation and since 1990 interest rates in parti cular have been the chief instrument. Until 1997 the Chancellor of the Exchequer set interest rates in the UK with advice from the Treasury and the Bank of England.

This, at times, particularly during the run -up to an election, meant that government could lower interest rates or postpone increases to help their chances of re-election, even when the correct economic action was to raise them. A major change took place in 1997 when the new Labour

Government gave the Bank of England independence in setting the interest rate required to achieve and maintain the underlying inflation rate, i.e. the RPIX at annual average of 2.5% (note that the target is now a 2% rise in the Consumer Price Index). This, therefore, removed the political influence from the setting of interest rates.

8.1 The Monetary Policy Committee

At the centre of the new arrangement is the Monetary Policy Committee of the Bank of England which sets interest rates each month. This committee of economists monitors various indicators of inflationar y pressure, such as house prices, factory gate prices, average earnings, and the amount of bank lending, and it takes steps to reduce these inflationary pressures before they result in a rise or fall in the 2% target. If the inflation target is missed by more than 1% above or below

2%, the Governor of the Bank of England, as chair of the MPC, must write an open letter (i.e. available to the public) explaining the reasons why the target has been missed and what the Bank proposes to do to bring inflation back on target.



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8.2 How do interest rates affect inflation?

When interest rates are changed, demand can be affected in a number of ways:

• Spending and saving decisions – an increase in interest rates will make saving more attractive and borrowing less at tractive, which in turn will reduce spending for both consumers and firms.

• Cash-flow – a rise in interest rates will reduce consumers’ and firms’ cash-flow, e.g. those with mortgages and loans will have to pay more in interest and will have less to spend on goods and services.

• Exchange rates – a rise in interest rates in the UK will attract foreigners to invest in the UK. This leads to an increase in the exchange rate against other currencies. An increase in the £ reduces the price of imports which helps to lower the CPI. Prices of UK exports rise and demand for them falls, which in turn reduces aggregate demand and inflationary pressure.

Supply-Side Policies

1 Introduction

You saw in Topic 1, National Income , that there is a conflict of view about what determines the level of national income and employment.

• The Keynesian view is that the level of aggregate demand is the main factor.

• The opposing view is that the supply side of the economy is more important. Followers of supply-side policies believe that unless potential output (i.e. supply) can be increased, any increase in demand will result in inflation or balance -of-payments problems.

They believe that government should target policy towards either increasing resources or improving their ef ficiency.

Most economists now accept that to achieve economic growth and increased employment both aggregate demand and aggregate supply need to be raised.



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2 Supply-side policies

Supply-side policies are mainly microeconomic measures designed to affect product markets (where goods and services are bought and sold) and those that aim to improve the working of labour markets .

2.1 Supply-side policies and product markets . The main thrust of these is to increase competition in the belief that competiti on between producers increases their efficiency and improves incentives.

These policies have included:

• Privatisation . This was the main policy on the product market side in the 1980s and 1990s. The privatisation of various large former state-run industries was designed to break up state monopolies to create more competition.

•

Deregulation . This involved government reducing its control and regulation of private industry, e.g. in bus transport, air travel, parcel delivery, telecommunications, gas and electricity supply. These industries had been protected from competition by government barring new entrants. The aim of deregulation was to open up these markets to greater competition leading to greater cost efficiency and wider choice for consumers.

•

Commitment to free trade . The UK Government has signed up to trade agreements made by the World Trade Organisation (WTO), and the UK is a full member of the European Single Market. Free trade promotes competition.

• Reduction in corporation tax . High rates of corporation tax reduce incentives to make profit. Lower tax rates encourage firms to invest in capital, so making them more efficient.

•

Strict control of inflation . Inflation creates uncertainty about the profitability of investment and therefore a cts as a disincentive to introducing new or replacement capital.

2.2 Supply-side policies for the labour market . A perfect labour market is one that can quickly clear surpluses or shortages. This is called a flexible labour market . An imperfect or inflexible labour market is one where it is slow for the market to adjust, e.g. difficult for employers to shed labour or reduce wage rates at a time of falling demand, or where it is difficult to recruit when demand is rising.



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Supply-side policies are designed to improve the quality and quantity of the labour. An expansion of the labour supply increases the productive potential of the economy. Increased quality will improve the productivity of labour.

Trade union reforms

Many legal protections enjoyed by the trade unions have been taken away – including the right to take industrial action and enter into restrictive practices agreement with employers, e.g. demarcation. The result has been an increase in the flexibility of the labour market, a decrease in strike action and an improvement in industrial relations.

Increased spending on education

The UK Government has increased spending on education as a percentage of GDP. There has been an expansion in the number of students at university. The aim is a well -educated workforce capable of working in the new highly productive technological or ‘knowledge based’ industries. A well-educated workforce also acts as a magnet for foreign investment in the economy.

Increased spending on training

The ‘New Deal (Welfare to Work)’ is designed to make the unemployed without skills more employable – it consists of a subsidy to employers to recruit and train those unemployed under 25 and the long -term unemployed.

Improved incentives to work

This can be achieved by the following methods:

• Reducing income tax

. Income tax is paid directly from earned income. Many economists believe that lower rates of tax improve incentives for people to work longer hours or take on more responsibility because they get to keep a higher pe rcentage of the money they earn. In the 1980s the Conservative government cut income tax rates across the board but the biggest reductions were given to higher income groups. The basic rate of tax has come down more gradually from 33% in 1979 to 22% today. Attention has focused in recent years on lower-income households. In the mid -

1990s a lower starting rate of tax of 10% was introduced and since then the band of income on which this is paid has widened. This is designed to reduce the unemployment trap – where people calculate that they may be better off unemployed than working.



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• Adopting a ‘make work pay’ policy

– the gap between unemployment benefit and the lowest rates of pay has been allowed to widen by linking unemployment benefit to the rate of infl ation rather than to the growth of earnings. (Earnings grow faster than prices.) Eligibility for Job Seekers Allowance has also been tightened up by claimants having to prove that they are actively seeking work.

• The introduction of the minimum wage has helped to encourage the unemployed into jobs which previously were considered to pay wages not worth working for.



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Policies to Reduce Unemployment: Summary

Possible cause of unemployment Policy

•

Cyclical unemployment



Demand-side policies – take steps to increase demand in the economy, perhaps by:

Fiscal policy

- lower taxation to increase consumer spending

- higher government spending.

Monetary policy

- lower interest rates

allow/encourage banking system to lend more.



Supply-side policies – take steps to improve the supply of resources:

- improve the flexibility of labour

- reduce direct taxes to improve enterprise and effort

- control inflation

- deregulate and privatise.



Exchange-rate policy

- devalue to lower the price of exports.



External-trade policy

- impose restrictions on imports.

• Frictional unemployment

• Structural/regional unemployment



Supply-side policies flexibility of labour.



Regional policies to attract inward investment.

to improve



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Policies to Reduce Inflation: Summary


• Demand–pull



Demand-side policies – take steps to reduce demand in the economy, perhaps by:

Fiscal policy

- raising income tax to reduce consumer spending

- reduce government spending.

Monetary policy

- raising interest rates

• Cost–push (wages)



- restrict banks’ ability to lend.

Supply-side policies

- de-regulate labour markets

- encourage greater productivity in industry.

• Cost–push (import prices)




raise the exchange rate by raising

interest rates – imports become cheaper.

•

Fast growth in money supply



Monetary Policy

- raise interest rates to reduce demand for credit

- reduce bank lending

- reduce government borrowing.

•

Expectations of inflation



Follow strict anti-inflation policies which show government’s determination to reduce inflation.



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Policies to Improve Balance of Trade: Summary


•

High demand for imports



Demand-side policies

Fiscal policy

- increase income tax to reduce consumer demand.

Monetary policy

- increase interest rates to reduce consumer borrowing

- restrict bank lending.




- devalue to make import prices dearer.



External-trade policy

• Low demand for exports



- introduce restrictions on imports.

Supply-side policies

encourage greater efficiency in

domestic industries.



External- trade policy

subsidise exporters

extend soft loans to foreign buyers.



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Economic Growth and Environmental Policy

1 The meaning of economic growth

1.1 Economic growth is the rate of growth of a country’s potential output.

This can be represented by a shift to the right of the country’s production possibility curve.

Consumer goods

Capital goods

1.2 In theory, economic growth is the growth in potential output, but, in practice, potential growth is impossible to measure, so growth in actual output is the usual measure. Economic growth in the UK is the annual percentage change in real GDP.

2 Causes of economic growth

2.1 Supply side of the economy

Potential growth

• an increase in the quantity of resources, or

• an improvement in the quality (productivity) of a country’s resources.

Quantity of resources

• Land – usually fixed in quantity but may increase in the long run if new supplies of natural resources are found, e.g. oil in the UK.

•

Labour – supply of labour is measured in man hours, so any increase in the numbers of people willing and able to work or in the ho urs worked will increase the labour supply.



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The workforce may be increased by:

– an increase in the number of people of working age, e.g. through immigration,

– an increase in the participation rate (the percentage of the working age group looking for work), e.g. in recent years there has been a large increase in the number of women workers.

• Capital – an increase in investment is usually the most important cause of economic growth. This could be financed by encouraging an increase in savings or by attracting inward investment from overseas.

Productivity of resources can be improved by:

(a) Moving resources from low-productivity industries to higherproductivity industries. This depends on making resources occupationally and geographically mobile, e.g. a policy of the present UK Government is to encourage the growth of knowledge-based industries. These are industries which use highly educated and skilled workers to produce sophisticated products which cannot be produced by low -wage countries.

(b) Improving the quality of resources, e.g.

•

Land – drainage, applying fertilisers.

• Labour – education and training, improvements in living and health conditions, improvements in industrial relations between workers and management.

• Capital – research and development into new technologies.

(c) Using resources in a more economically efficient way, e.g. specialisation; producing on a large scale to gain economies of scale.

3 Actual growth

Actual growth is determined by two factors:

(a) the growth in potential output

(b) the growth in aggregate demand.



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4 Government policy and economic growth

4.1 There are two possible approaches:

(a) Left-wing politicians and economists believe that government should intervene in the economy. Th e interventionists would have government investing in industries and providing subsidies to private-sector firms to help them to invest. They also believe that government should invest heavily in the infrastructure of the country, e.g. in transport, commun ication and housing. This would help to increase the potential output of the economy. Government should also where necessary increase aggregate demand in the economy through appropriate fiscal and monetary policies.

(b) Right-wing politicians and economists believe that private-sector initiative and enterprise generate growth, and that government should restrict itself to removing as many as possible of the controls and regulations on the private sector in order to allow enterprise to thrive. A key part of the policy is to reduce direct taxes on incomes and profits to encourage enterprise and effort.

Strict control of inflation is also necessary to allow industry to compete and thrive in world markets. A boost in supply of goods and services would create its own demand.

4.2 Present UK Government policy combines parts of these two approaches and its aim is to achieve sustainable economic growth. Sustainable economic growth is growth in demand and output without increasing inflation.

5 Benefits of growth

5.1 Standards of living improve. (But note that general prosperity will only increase if increased income is shared out among all sections of the population.)

5.2 Increased productivity may allow more to be produced in less time – hours of work may be reduced – shorter working weeks; longer holidays.

5.3 Increased incomes for those in employment yield higher tax revenues for government. More and better public services can be provided.



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6 Costs of growth

6.1 In the short run, living standards of consumers may fall if resources are switched from making consumer goods to making capital goods.

6.2 In the long run, economic growth may cause external costs such as:

• pollution

• depletion of non-renewable resources

• increased pressure of industrial and urban life, e.g. crime, stress.

7

Britain’s performance

UK economic growth (annual % change in real GDP

Since the recession of 1990 to 1992 the UK economy has grown each year. This is the longest period of continuous growth since the 1970s.

For most of those years growth has been at or above the long-term trend of 2.5% per annum. Although this is a good performance for the UK, its growth rate is lower than that of other major industrialised nations such as the USA, Germany and France. A notable feature of the UK economy has been the poor performance of the manufacturing sector compared with the service sector.



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7.1 Sources of growth

In recent years growth has resulted from both demand and supply factors. On the demand side:

• Since the late 1990s there has been strong consumer demand:

– with low unemployment consumer confidence has been high

– consumers have been able to increase their borrowing using higher house values as collateral

– interest rates have been low, making borrowing cheap.

• Low inflation and low interest rates have encouraged firms to increase investment.

• Since 2001 there has been a significant increase in government spending on health, education and transport.

• Against this the growing trade deficit has moderated the rise in aggregate demand.

On the supply side:

• The increase in the female participation rate has increased the size of the workforce.

• The increasing flexibility of the workforce has increased productivity.

• Higher investment has added to the country’s productive capacity.



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Environmental Policy

1 Environmental problems

The impact of economic activities (production and consumption) on the environment has become a matter of great concern in more recent times.

Problems include:

• global warming

• air pollution

• water pollution

• traffic congestion

• depletion of non-renewable energy resources

• landfill waste.

Environmental problems are an example of market failure, i.e. they are external costs which are not considered by the producers or consumers who create them.

2 Government policies

Governments are taking greater interest in implementing policies that are designed to protect or improve the environment. These policies may be:

• market based

• non-market based.

2.1

Market-based policies .

Market-based policies are those that aim to influence producers or consumers by the price which they have to pay.

They aim to discourage producers or consumers by making them pay for the external costs they create. This is usually done by imposing taxes or imposing charges. This is often called the ‘ polluter pays principle’

.

Examples include the landfill tax, climate change levy, car parking charges, congestion charging and taxes on road vehicle fuel.

Landfill tax encourage businesses and councils to minimise waste and encourage recycling.

This is a tax for every tonne of waste used for landfill. It is desi gned to

Climate change levy

The UK Government introduced this energy tax in 2001. The tax is paid



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THE UK ECONOMY by companies on the energy they use and is designed to encourage energy efficiency and cut industrial emissions. This tax is designed to help the UK move towards the government’s target of a 20% reduction in carbon dioxide emissions between 1990 and 2010. The revenue raised will be recycled to business through a reduction in the rate of employer

National Insurance contributions. The background to this tax is the

Kyoto Treaty on Global Climate Change, a global treaty to reduce emissions of greenhouse gases which was agreed in Kyoto, Japan. This commits developed countries to make r eductions in emissions of carbon dioxide by 2010. The UK is making good progress towards this.

Road pricing

This involves charging motorists a fee for travelling on a congested road. It is designed to encourage motorists to:

• substitute their car with a cheaper means of travel which is more environmentally friendly, e.g. public transport

• conserve fuel, e.g. by cutting out unnecessary journeys.

Road pricing has been introduced in London and is being considered by a number of local councils, such as Edinburgh.

Petrol tax

Rates of duty on diesel and petrol have for a number of years been rising faster than inflation ( the fuel tax escalator ). This is designed to persuade motorists to use their vehicles less often.

VAT on domestic fuel

VAT on domestic fuel (now 5%) was introduced in 1993, supposedly to cut fuel consumption.

2.2

Non-market policies . Non-market policies are those which impose direct controls on polluters or which involve government investment with the taxpayer paying the bill. These are financed out of taxation or are self-financing.

Direct controls include setting pollution standards and enforcing them, e.g. firms may be fined for discharging pollutants into the atmosphere and water.



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Government investment has included:

• investing in park-and-ride schemes

• investing in improved sewage disposal

• investing in research into renewable forms of energy

• providing for recycling projects such as bottle banks, waste paper collections, aluminium can collections.

2.3 Other factors . Many firms are becoming environmentally friendly because they have discovered that

• ‘Green’ business is good business. A reputation for being environmentally friendly attracts customers.

• Cutting down on waste, conserving energy and recycl ing can save money.

• Pressure groups such as Friends of the Earth and Greenpeace can mobilise consumer opinion against irresponsible companies.



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Market Failure and Government Policies

1 Introduction

1.1 You will remember that the main function of mar kets is to allocate resources efficiently. This includes both technical efficiency and allocative efficiency. Competition in markets encourages firms to keep down their costs by using efficient methods of production. Competition also encourages firms to be enterprising and innovative using resources to make those products most wanted by consumers.

1.2 Definition – Market failure occurs when a market fails to supply the type or quantity of goods or services demanded by consumers. This means that there is economic inefficiency in that market.

1.2 The main causes of a market failing are when:

(a)

(b)

(c)

(d)

Competition is restricted.

External costs and external benefits are ignored.

Public goods cannot be provided.

Merit goods are not provided to all c onsumers who need them.

1.3 When a market fails then there is a case for government intervention to make the market work efficiently.

2 Restricted competition

2.1 Competition encourages producers to increase efficiency. Any restriction of competition by, e.g. monopolies, mergers or restrictive trade practices results in

• poorer-quality goods

• limited supplies

• inefficient use of resources or

• higher prices.

2.2 Government policy on competition . The aim of competition policy is to encourage competition. This involves taking action to prevent or remove anti-competitive behaviour. The Office of Fair Trading is responsible for investigating breaches of competition law and for enforcing the law as set up in the Enterprise Act 2002. It investigate s and, if necessary, stops monopolies and mergers, and any practice which restricts trade such as cartels.



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2.3 Monopoly investigations.

Any firm with a market share of above 25% may be referred to the Competition Commission for investigation if it is suspected of acting against the public interest.

2.3

Merger investigations . Any takeover or merger, which would result in a combined market share of 25% or if assets exceeded £30 million, may be investigated and disallowed if thought to be against the publi c interest, e.g. Lloyds TSB was prevented from merging with Abbey

National because it would have led to reduced competition in the market for personal and small -business banking services.

2.4 Restrictive trade practices. Restrictive trade practices aim to control the market in some way. These practices include:

• Resale price maintenance . This is when suppliers try to force retailers to charge a certain price. This is illegal although it was allowed in the markets for books and non -prescriptive medicines up until recently.

• Predatory pricing . This is when a supplier charges a very low price in a market to drive out a competitor. Where this has happened the predator has been usually a large company which can afford to subsidise the low price from its other profitable activities.

•

Distributing only to certain retailers , e.g. Tesco recently complained that Levi Strauss refused to supply it with jeans.

• Cartels . A cartel is an agreement between suppliers to fix prices, share out markets or contracts.

All of the above practices, which restrict trade and free competition, are now illegal.

2.5 Monopolies or mergers may be allowed if they are in the public interest.

This is when:

• Competition is maintained. A market, which consists of a smaller number of more equally sized firms, may be more competitive than one which consists of a large firm and a number of small firms. The market may be international so that even if there is only one firm in the UK, it may still face competition from overseas.



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• The competitive strength of a UK company is increased in overseas markets.

• The development of new products is more likely.

• Costs of production are reduced as a result of economies of scale.

• The interests of consumers are improved, e.g. lower price s, better quality, increased choice, and safer products.

2.6

EU competition law . In addition to UK government legislation, the

European Commission may also investigate a proposed merger or takeover which is on a European scale.

3 External costs and benefits

3.1 In a free market, the costs which a firm takes into account when making decisions are those which it has to pay, i.e. private costs. Similarly a consumer when making decisions about what and how much to buy only considers private benefit , i.e. the benefit (utility) which s/he receives.

3.2 However, the production and consumption of a product may have spillover effects on people not directly involved in its production or consumption. These spillover effects are called external costs and benefits.

3.3 External cost . External costs (or negative externalities as they are sometimes called), are those costs which are not paid for by the producer and are not included in the calculation of the price charged to the consumer. These are incurred by others.

Examples : a paper mill does not include in its costs of production the cost of cleaning up a polluted river which has been used for the disposal of its waste; a chip shop does not include in its costs the cost of tidying up discarded wrappers. These costs will be borne by taxpayers for the clean-up or by those who are harmed in some way, e.g. fishermen, local residents.

3.4 Social cost . Social cost is the cost to society of all the resources used as a result of the production and consumption of a produc t.

Social cost = Private cost + External cost



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3.5 External benefit . The production and consumption of some products give benefit to some consumers who do not pay for them.

Examples : the price paid for a drug to cure an infectious disease reflects the benefit to the patient but there are external benefits to others who will not now catch the disease. The building of a new motorway brings benefit to those who do not directly use it, e.g. those who own motorway cafes.

3.6 Social benefit . Social benefit measures the total benefit obtained from the consumption of a product.

Social benefit = Private benefit + External benefit

3.7 Market failure . If producers of a good, e.g. alcohol, do not consider external costs then the output will exceed what it ideal ly should be, and resources will have been over -allocated to the production of this good.

In the diagram below:

(a) If a free market exists, the quantity produced will be Y at price P y

, i.e. where the demand and supply curves meet.

(b) If social costs (including crime, health costs) were taken into account, then the output should be X at price P x

, demand would be lower and fewer resources would be used.



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3.8 If an industry creates external costs, government can intervene by:

(a) imposing direct controls on the industry, e.g. limit pub opening hours or limit the number of consumers by age

(b) imposing a tax (e.g. in the previous diagram) equal to the external cost. This has the effect of moving the supply curve to the left.

Price would rise and the quantity consumed and produced would fall.

3.9 If producers of a good do not consider external benefits then the output will be less than it ideally should be, e.g. an external benefit of an urban bus service is the reduction of road congestion . The bus operating company will not consider this benefit because it does not receive any money for it. The company may not provide the service or may not provide it so frequently because it is non -profit making. In the diagram below:

(a) if a free market exists, the amount of the good produced will be A at price P

A

, i.e. where the demand and supply curves meet.

(b) if social benefits (including reduced pollution, less congestion) were taken into account, then the output should be B at price P

B

, demand would be greater and more resources would be allocated to this service.



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3.10 To encourage the provision of 0B, government could intervene and give a subsidy equal to the external benefit (XZ) to the bus company. Price would fall and consumers would use the service more.

4 Public goods

Note that most of what we call public goods are actually services, although you should still call them public goods.

4.1 A public good such as defence or street lighting has three main characteristics:

• A consumer can consume it without reducing the amount available to others – contrast this with a private good like a bag of salt and vinegar crisps.

• The producer, i.e. the Government, cannot exclude any consumer from consuming the service. Contrast this wi th a bag of crisps where the producer can exclude you if you do not pay the price.

• A consumer cannot choose not to consume the service, whereas with a bag of crisps if you do not like them you do not have to buy them.

4.2 Public goods would not be provided in a free market system because there is a ‘free-rider’ problem, i.e. consumers could consume without paying so producers would not receive sufficient income to cover costs.

4.3 Government therefore has to provide public goods and raise the required revenue from general taxation.

5 Merit goods

5.1 Merit goods are so called because they are given to those people who merit (i.e. need) them, either free or at reduced price. Merit goods are goods or services which are socially desirable but which would be under-produced if left to private enterprise. They would only be provided to those who could afford to pay the full economic price.



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Notice that in contrast to public goods they are:

• Rival – if you are using a hospital bed or university place th is prevents someone else from using them.

• Excludable – you can be excluded from using a merit good, e.g. hospital beds or university places are only given to those who merit them.

• Rejectable – in most cases a consumer can decide not to consume the service.

5.2 In a free-market economy there would be wide differences in income and wealth so that citizens on low incomes could not afford certain desirable services. In a mixed economy, government may intervene by providing merit goods such as education and healthcare, and benefits such as unemployment compensation, child benefit, etc. The finance comes out of taxation, much of which bears more heavily on the rich.

5.3 Many economists and politicians argue that interfering with income distribution does little to improve economic efficiency but they accept the need for it on the grounds of equity , i.e. fairness.



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Inequalities of Income and Wealth

1 Equity

A characteristic of market economies is inequality of income and wealth. Governments intervene to red uce inequalities and this is done to promote equity, i.e. fairness.

2 Income

2.1 Income is the amount that people earn in a period of time and includes earnings from investments, from work, and from social benefits.

2.2 Income is unevenly distributed because of:

• age and unemployment

• uneven distribution of skills and talent

• different education opportunities across families and across the country

• unequal ownership of wealth.

2.3 Income has become more unevenly distributed since the 1980s. The gap between rich and poor has widened because of:

• fewer jobs in manufacturing but more in services, many of which are part time and low paid.

• reduced bargaining power of many workers.

• an ageing population structure so that there are more retired people on lower incomes.

• taxation becoming more regressive, which has benefited high -income earners more than low-income earners.

• social benefits being linked to prices rather than earnings as they were before – average earnings have been rising faster than prices.

3 Wealth

3.1 Wealth is what people own. It refers to their assets: real, e.g. houses; and financial, e.g. bank accounts and share portfolios.

3.2 Wealth is unevenly distributed:

• savings – distribution of income affects people’s ability to save

• inheritance.



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4 Government policies

4.1 All governments have policies for reducing inequalities, but the debate is usually about the extent of redistribution rather than the principle.

4.2 For a government wanting to reduce inequality, pol icies could include:

• introducing a national minimum wage

• helping more people into employment

• providing more job training

• making income and wealth taxes more progressive

• reducing tax and national insurance contributions on low incomes

• restructuring welfare payments to target those in greatest need

• linking welfare payments to earnings rather than prices

• providing more merit goods and/or raising the cut -off points for free provision.

5 Case against further intervention

• Higher direct taxation may damage work incentives, job search incentives, saving and risk taking

• Reduced incentives would lower national income out of which higher social benefits can be paid – the ‘trickle-down’ effect.



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Regional Policy

1 Introduction

Differences in prosperity exist between different parts of the country.

These disparities are usually due to industrial decline and/or a failure to attract new industry. In areas of decline there will be a number of economic and social problems, e.g. above -average unemployment, low average income, migration of population. In the UK reference is often made to a ‘north–south divide’ which indicates that the south of

England is more prosperous than the rest of the country. The south is said to be more attractive to modern manufacturing and service industries. The attractiveness of the south has created problems in the south, e.g. shortages of labour, high house prices, traffic congestion, etc. There has been much debate about how far government should intervene to reduce these inequalities.

1.1 Non-interventionists argue that:

• Wage rates, if left to free-market forces, will be less in the poorer regions, attracting firms to move there.

• Prosperous regions will become overcrowded and congested, and high costs will drive firms away.

1.2 Interventionists argue that:

• Labour is geographically immobile so there is a need for government assistance to encourage new firms to move to less favoured areas.

• Areas of industrial decline need to be made attractive to new firms by improving their infrastructure, e.g. motorway network, rail, port and air facilities, housing, etc.

• Labour is occupationally immobile so training is required.

2 Regional policy

2.1 Government policies towards helping regions with economic pr oblems have gone through many changes. The present policy aims to:

• direct resources to the poorest areas

• make regional aid cost effective.



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2.2

Certain parts of Scotland have been designated ‘Assisted Areas’.

Assisted Areas fall into two categories :

• Development Areas

• Intermediate Areas.

2.3 Firms expanding in Assisted Areas can apply for Regional Selective

Assistance (RSA). Under RSA, grants are offered for investment projects which create or safeguard employment. The amount given is the minimum sum necessary to ensure the project goes ahead.

2.4 In Development Areas, which are areas of greater need, new or expanding small firms are also eligible for Regional Enterprise Grants which cover 15% of investment cost.

2.5 In 1990, Scottish Enterprise (SE) and Highlands and Islands Enterprise

(HIE) were set up to oversee economic development, environmental improvement and training in Scotland. SE and HIE dispense money to

Local Enterprise Companies (LECs) and authorise how they spend it. A board made up mainly of private-sector business people who are supposed to be aware of the problems and potential of their local area runs each LEC. The LECs are responsible for designing and delivering projects in their areas and for operating training schemes.

2.6 Scottish Enterprise is also responsible for the ‘Locate in Scotland’

Agency whose main task is to market Scotland internationally as a business location and to attract foreign firms to Scotland.

3 European regional policy

3.1 The European Regional Development Fund provides support to more depressed industrial and rural areas within regions of the EU. In

Scotland, the industrial areas of Strathclyde, parts of Fife, Tayside and

West Lothian have received help and the rural areas of the Highlands and Islands have been eligible for European assistance. Grant aid was given for tourism and manufacturing investment as well as for major infrastructure projects, such as road building, new harbour facilities, telecommunications, etc. However, with EU enlargement , a number of the much poorer countries from Eastern Europe now have a bigger claim on assistance from the Regional Development Fund.



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The Scottish Economy

1 Changing pattern and structure in recent years

1.1

Output . The importance of services and ene rgy has increased at the expense of manufacturing.

In common with the rest of the UK economy, manufacturing output has failed to grow because of the declining competitiveness of manufacturing industry. For more detailed reasons, see previous notes.

Note that there has been a decline in traditional manufacturing industries such as steel and shipbuilding and also a decline in the numbers employed in modern industries like electronics.

Rising real incomes have increased the demand for services , e.g. the growth in output of the hotel and catering industry can be attributed to the increasing number of people who go for meals out, weekend breaks and second holidays; the growth in financial services has arisen from rising incomes and house ownership. Unlike man ufacturing, service industries are more insulated from foreign competition.

Energy output increased throughout the 1970s and 1980s although it slowed in the late 1980s and 1990s. Output in coal declined markedly while oil and gas production rose, although this has now flattened out.

1.2

Employment

• Manufacturing employment has fallen. Some industries, e.g. shipbuilding and textiles, have declined and others have become more capital intensive.

• Employment in the energy sector has fallen mainly in the coal industry.

• Employment in the service sector has risen because of rising output of service industries and the increasing number of part -time workers.

1.3 Regions

• Changes in output and employment have been reflected in the regions of Scotland.



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• Borders and Lothian regions have increased their share of Scottish

GDP. This reflects the importance of service industries in these regions.

• Grampian has increased its share of GDP as a result of the continued success of oil and gas production.

• Strathclyde’s share of GDP has fallen because of its heavy reliance on manufacturing.

2 Regional differences within Scotland

2.1 Between the regions of Scotland, inequalities exist in rates of unemployment, GDP per head and average earnings.

2.2 In Strathclyde and Tayside:

• There was a high proportion of declining industry, e.g. shipbuilding, textiles, steel and coal.

• The new expanding industries, which tend to be capital intensive, have not grown sufficiently to absorb the excess labour.

• Even some of the ‘new’ manufacturing industries, which developed after the Second World War, have declined.

• The old urban areas have been less attractive to modern industry.

2.3 In south-west Scotland and in the Highlands and Islands:

• Agriculture, forestry and fishing are the dominant industries – demand for labour is low.

• Tourism is largely a seasonal employer and incomes are low.

2.4 North-east Scotland has prospered with oil and gas related industries.

2.5 Lothian and Borders have prospered.

• Edinburgh is the administrative and financial centre of Scotland.

• Although the electronics industry is widely scattered, the main concentrations are in the Edinburgh and south Fife areas.



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3 Foreign firms in Scotland

3.1 These have been very important to the Scottish economy.

Approximately 10% of manufacturing plants are foreign owned, and

50% of these are American. The proportion of Scots employed in foreign firms is higher than the UK average.

3.2

Advantages for foreign firms

• skilled labour force

• low wage rates relative to some other areas of the EU

• inside the EU tariff barrier

• good infrastructure

• financial inducements from central and local government

• external economies of scale (particularly for electronics), e.g. a concentration of local suppliers and services.

3.3

Advantages for Scotland

• employment

• incoming firms come with advanced technical and managerial skills

– existing firms have copied these skills

• wider choice of products for consumers

• profitable companies – pay good wages and provide good working conditions; local multiplier effects benefit people working in other industries, e.g. local services

• boost Scottish exports.

3.4

Disadvantages for Scotland

• Research and development may take place in country of origin. Plant in Scotland may be a ‘screwdriver’ plant, i.e. only providing low skilled assembly jobs.

• ‘Branch factory’ problem, i.e. multinational may close or reduce size of branch factories more readily in times of recession than Scottish firms.

• When grants run out there is nothing to tie the firm to Scotland.



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Economics The UK Economy [INTERMEDIATE 2;

Economics

The UK Economy

[INTERMEDIATE 2;

HIGHER]

Martin Duguid

Contents

Unit 2

Topic 1: National Income

Circular Flow of National Income

This section (to page 19) is for Higher only

The Determination of National Income

Keynesianism: the Demand Side of the Economy

Monetarism – The Supply Side of the Economy

Business/Trade Cycles

Topic 2: Inflation and unemployment

Inflation

Section 6 is for Higher only

Unemployment

Section 6 is for Higher only

Topic 3: The Role of Government in the Economy

Economic Systems

Public Expenditure and Finance in the UK Economy

Government Economic Objectives

Topic 4: Government Economic Policies

This topic is for Higher only

Demand and Supply Sides of the Economy

Fiscal Policy

The rest of these notes are for Higher only

Monetary Policy

Supply-Side Policies

Policies to Reduce Unemployment: Summary

Policies to Reduce Inflation: Summary

Policies to Improve Balance of Trade: Summary

Economic Growth and Environmental Policy

Capital goods

Environmental Policy

Market Failure and Government Policies

Inequalities of Income and Wealth

Regional Policy

The Scottish Economy

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