A2 and AS Revision – April 2013 Developments in the UK Economy · Growth in the UK Economy ....

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A2 and AS Revision – April 2013 Developments in the UK Economy

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

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

1. Output: Real GDP remains well below output levels before the recession began. GDP has recovered at a pace of just 1% annualised since the end of the recession.

2. Fragility: Recovery from the recession has been weak and fragile. Output grew by less than 1% in 2011 and actually fell again in 2012. According to the National Institute for Economic Research, “This period of depressed UK output is now significantly longer than that experienced during the Great Depression.”

3. Weak private sector: A key weakness for the UK has been the low growth of private sector demand. A number of factors are holding back consumption including falling real incomes, low confidence, high levels of existing household debt and the high cost of unsecured loans. Stagnant house prices also a factor.

4. Low investment: Business capital spending has also been low – it collapsed by nearly 14% in 2009 and has struggled to recover momentum ever since despite many businesses holding record levels of cash. Lots of businesses seem to be reluctant to give the go-ahead for new capital projects.

5. Credit scarcity: The private sector in the UK has been weak in part because of the lack of credit from the financial system. Many commercial banks continue to de-leverage (cut their loan books) and business finance is hard to get at an affordable rate of interest. Several policies have been introduced in the last two years to encourage more lending, but with mixed results thus far – latest is Funding for Lending

6. Slow export growth: Exports were expected to be a driver of recovery for the UK but after two relatively good years in 2010 and 2011, the rate of growth of exports sold overseas has dropped once more.

7. Spare capacity: The result of weak growth in the last few years is that the UK economy is operating with a negative output gap – GDP is well down on potential output and one consequence is a high rate of unemployment. That said, the 8% unemployment rate is lower than after previous recessions although long-term unemployment and youth jobless rates are two difficult structural problems

8. Fiscal debt and fiscal austerity: The high level of government borrowing is shown in the table with figures for the annual fiscal deficit. Peaking at over 10% of GDP in 2009 and 2010, the Coalition government have made deficit reduction a key pillar of their macroeconomic policies and have focused on spending cuts rather than tax rises as part of their fiscal austerity programme.

9. Inflation and real incomes: Inflation in the UK has been above the 2% target for CPI over most of the last five years. External factors such as high global commodity prices, a weaker currency and the rising price of energy have been three important reasons for inflation staying above target range. Persistently above target inflation has cut real incomes.

10. Trade deficits: The UK continues to run a current account deficit on the balance of payments, the main reason for this is the widening trade deficit in goods which rose above £100bn for the first time in 2011.

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Growth in the UK Economy

Output for the UK economy in the recession in the years 2008-09 fell by 6% from peak to trough and recovery since then has been slow and fragile. The UK suffered a deeper recession and has seen a weaker recovery than many other nations. Several factors help to explain this slow growth:

• Falling consumer spending as real incomes fall and people have struggled to pay off existing debts • Low business confidence and weak demand has held back capital investment spending • Export growth has been affected by low demand in the EU (Britain’s biggest export markets) and

difficulties among exporting businesses in securing export finance / trade credit • Increasingly deep cuts in the real level of government spending and rising taxes as part of the

Coalition’s fiscal austerity programme • Demand has not responded as much as expected to a period of expansionary monetary policy

including record low base interest rates, quantitative easing and a new credit easing scheme

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

1. Currency depreciation (a fall in the external value of sterling against other currencies) a. A boost to UK export competitiveness – it makes UK unit labour costs and prices lower b. Improved net trade balance (over time) – providing export demand responds

2. Supply-side support for industry a. Establish more technology innovation centres b. Increase number of graduates and apprentices in technical subjects c. Lower corporation tax – reduced to 21% in the March 2013 budget

3. Improving the supply of credit in the financial system a. Project Merlin – a voluntary agreement with the banks b. Credit easing scheme – government loan guarantees c. Funding for lending scheme (FLS) d. Green Investment Bank for renewable investment schemes e. Encouraging new entrants into the retail banking industry



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

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

1. Low research and development spending as a share of GDP 2. Falling share of capital investment as a share of GDP (low business confidence) 3. Slow economic growth in the European Union – Britain’s biggest market for exporting products 4. Volatile and regressive housing sector causing low labour mobility 5. Few small/medium businesses export to emerging countries 6. High long-term unemployment is a major drag on economy – this is creating hysteresis problems 7. A creaking national infrastructure, other countries overtaking in terms of transport networks and

telecommunications capacity and speed 8. Financial system continues to be fragile with low lending to businesses – the credit crunch in the UK

has effectively lasted for six years now 9. There are signs now of a productivity slowdown in the UK economy. Output per worker in the UK at the

end of 2012 was lower than it had been at the end of 2006 10. Fiscal austerity – deep cuts in government spending and higher taxes are likely to be a major constraint

on demand and output in the UK for a few more years yet

Productivity Improvements - an

increase in capital and labour input efficiency

Labour Market Participation i.e.

increasing the percentage of the

population of working age who are

economically active

Innovation and Enterprise -

encouraging businesses and industries that can

create high value added products

Capital investment to boost capacity and

lower unit costs. Includes infrastructure

investment projects



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

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

Source: OECD World Economic OutlookUK - Potential GDP and Trend Growth

Source: OECD World Economic Outlook

04 05 06 07 08 09 10 11 12 13 14-4

-3

-2

-1

0

1

2

3

4

5

6

7

8

9Pe

r cen

t

-4

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

% Change in Employment

Estimated UK Trend Growth Rate

Unemployment rate (%)

Index of output per hour worked, whole economy, seasonally adjustedUnited Kingdom Labour Productivity

Source: Reuters EcoWin

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

65

70

75

80

85

90

95

100

105

Inde

x

65

70

75

80

85

90

95

100

105



Monetary Policy in the UK

• Monetary policy works by changing the rate of growth of demand for money; changes in interest rates

affect the spending and savings behaviour of households and businesses • Because of the time lags involved in setting an appropriate level of interest rates, in the UK the Bank of

England sets rates on the basis of hitting the inflation target of 2% for the consumer price index over a two year forecasting horizon

• The Bank of England has been independent since 1997 • The UK operates within a floating exchange rate system and has done since we left the exchange rate

mechanism (ERM) in 1992. Changes in policy interest rates still have an effect on the demand and supply of currencies in the foreign exchange rate markets

• Since 2009 the BoE has operated a policy of quantitative easing as an extra tool of monetary policy

The policy of ultra-low interest rates Ultra-low interest rates are an example of accommodatory monetary policy i.e. a policy designed to deliberately boost AD and output. In theory cutting nominal interest rates close to zero provides a big monetary stimulus to the economy:

• Mortgage payers have less interest to pay – increasing their effective disposable income • Cheaper loans should provide a possible floor for house prices in the property market • Businesses will be under less pressure to meet interest payments on their loans • The cost of credit should fall encouraging the purchase of items such as a new car or kitchen • Lower interest rates might cause a depreciation of sterling boosting the competitiveness of exports • Lower rates are designed to boost consumer and business confidence

per centMonetary Policy Interest Rates, GDP Growth and CPI Inflation in the UK

Source: UK Statistics Commission

04 05 06 07 08 09 10 11 12 13

Perc

ent

-2

-1

0

1

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Perc

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-2

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7Policy Interest Rates

Consumer price index

Perc

ent

-4-3-2-101234

Perc

ent

-4-3-2-101234

Real GDP Growth Rate



Some economists argue that in current circumstances, the usual transmission mechanism for monetary policy may have broken down and that cutting interest rates has little effect on demand, production and prices. Several reasons have been put forward for this:

1) The unwillingness of banks to lend – most banks are de-leveraging (cutting the size of loan books) 2) The incentive to lend when interest rates are at such low levels is reduced 3) Low consumer confidence – people are not prepared to commit to major purchases – recession has

made people risk averse as unemployment rises. Weak expectations lower the effect of rate changes on consumer demand – i.e. there is a low interest elasticity of demand.

4) Huge levels of debt still need to be paid off including over £200bn on credit cards 5) Falling asset prices – and expectations that property prices will continue to fall

The chart above shows how bank lending to various sectors of the economy has remained weak since 2009. A negative growth rate means that the annual level of lending is falling. The Liquidity Trap In the 1930s, Keynes referred to a liquidity trap effect – a situation where the central bank cannot lower nominal interest rates any lower and where ‘conventional’ monetary policy loses its ability to impact on spending. Paul Krugman has defined the liquidity trap as “a situation in which conventional monetary policy loses all traction.” When interest rates are close to zero, people may expect little or no real rate of return on their financial investments they may choose instead simply to hoard cash rather than investing it. This causes a fall in the velocity of circulation of money and means that an expansionary monetary policy appears to become impotent. This means that different approaches are called for in order to stabilize demand in an economy on the verge of a depression including quantitative easing

12 month growth rate in lending, seasonally adjusted, per centRate of Growth of Bank Lending to UK Sectors

Construction Hotels and restaurants

Manufacturing Total lending to UK businesses

Source: Bank of England

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q305 06 07 08 09 10 11 12

Annu

al p

erce

ntag

e ch

ange

-20

-10

0

10

20

30

40

Annu

al p

erce

ntag

e ch

ange

-20

-10

0

10

20

30

40



Sterling Exchange Rate

• The UK operates with a free-floating exchange rate • The external value of sterling is determined by market forces of supply and demand • Sterling depreciated by more than 20% from late 2007 through to the end of 2008 • The effective exchange rate index measures the overall value of sterling against a weighted basket of

leading currencies • Since 2009 sterling has been fairly stable although there was appreciation in the first half of 2012 • A lower exchange rate was a helpful boost to the UK’s competitiveness during the worst of the financial

crisis and the subsequent recession • It has helped to achieve a modest re-balancing of the economy towards exports, but the expansionary

effect of a lower pound has been limited by a number of other factors: o High income elasticity of demand for imported goods and services o Some weaknesses on supply-side of the economy (i.e. research / investment) – a fall in the

exchange rate does not fundamentally change a country’s non-price competitiveness o Many UK businesses are finding it hard to finance a rise in exports (credit squeeze) o The majority of UK exports go to slow-growing countries in Europe and USA



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

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

• Rate of unemployment and the rate of inflation – more people out of work causes welfare bills to rise, inflation causes an annual increase in most benefits although the government now seeks to cap annual rises to 1%

• Growth of real incomes and profits – slow growth and weak profits hits tax revenues flowing into the UK Treasury

• Scale of government spending including welfare – the coalition prefers cuts in real spending on public sector services over tax rises as their strategy for cutting the fiscal deficit

• Effects of changes in tax rates on both direct and indirect taxes

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

Source: OECD World Economic Outlook

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

Per c

ent o

f GD

P

35.0

37.5

40.0

42.5

45.0

47.5

50.0

52.5

Per c

ent o

f GD

P

35.0

37.5

40.0

42.5

45.0

47.5

50.0

52.5

Total Tax Revenue

Total Government Spending


A2 and AS Revision – April 2013 Developments in the UK Economy · Growth in the UK Economy ....

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