EC-111 British EconomyRecent UK

Macroeconomic Trends

Dr Catherine RobinsonF35, Richard Price Building

Office Hours: Monday 10:30 to 11:30 and Thursday 9:30 to 10:30

Appointments: c.robinson@swansea.ac.uk

Week 2:1

Balance of PaymentsDuring the 1950s and 1960s there were continual

problems with BofP deficits...

Governments thereforeManipulated aggregate demand (stop-go policies)Adopted exchange control measures to keep the

external account in balance (devaluation a last resort in 1967 -14%)

Other policies such as investment incentives to promote capital formation and long run economic growth

REPRESENTS A NARROW INTERPRETATION OF KEYNESIAN THINKING (MAYNARD, 1989)

Week 2:2 3

DID IT WORK?The post war period was characterised by a shift to

Keynesian type policiesFull employment was the target policy objective

On the whole, it was considered to be a good period of macroeconomic stability and growthUnemployment was held at 2% or below for most of

the 1950s and 1960sGrowth was generally steady and although low, this

was thought to be due to sociological characteristics of the UK rather than policy failure

Balance of payments were troublesome, but manageable

Week 2:2 4

Opportunity wasted?Conditions post war were conducive a stable

macro economy Rebuilding war-torn EuropeFixed exchange rates Inflation tied to global rate, determined by US

macro policyTerms of trade favourable for industrialised

countires

And so had little to do with Keynes..

Week 2:2 5

Change in circumstances Things started to go wrong at the start of the 1970s

The collapse of the IMF monetary system (Bretton Woods) Worldwide burst of inflation Terms of trade worsened

Global oil crises 4 fold increase in oil price between 1973-1974

A freely floating exchange rate had implications for policy Fiscal expansion would force up interest rates and therefore

exchnange rate, reducing private sector demand.

A wage-price spiral was set in motion the breakdown of the Philips Curve

Stagflation – high unemployment AND high inflation

Week 2:2 6

Inflation (MM23 CPI annual %change)

19451946194719481949195019511952195319541955195619571958195919601961196219631964196519661967196819690

1

2

3

4

5

6

7

8

9

10

Week 2:2 7

Inflation in the 1970s

1970 1971 1972 1973 1974 1975 1976 1977 1978 19790

5

10

15

20

25

30

Note the change in scale

Week 2:2 8

Inflation (MM23 CPI annual %change)

-5

0

5

10

15

20

Week 2:2 9

So, what to do?Money was the answer…

A number of academic think-tanks were looking at the problem

National Institute of Economic and Social Research

The Cambridge Economic Policy Group Did not follow the mainstream Keynesian school of

thought Believed that the market was inherently stable and

constant fine-tuning approach was inappropriate Thought that a poor Balance of Payments position was

not helped but actively hindered by fiscal policy

Week 2:2 10

Cambridge Economic Policy Group

Simple message based on national income accounting: If I+G+X=S+T+MThen X-M=S-I+T-GThat is

balance of payments =f(private sector surplus (savings-investment) + public sector surplus (taxes net of government expenditure)

Private sector surplus is so small, that it can be virtually ignored

Therefore – its all down to government expenditure and tax receipts

Such that: X-M≈T-G

Week 2:2 11

What does this mean?The policy implication of such a model is that

any stimulation policy in fiscal terms must be accompanied by import controls, otherwise, a balance of payments deficit will ensue.

Apply a “Fiscal Rule” within the context of a medium term strategy for stability

Stick to the rule and only alter the “par” tax rate for major disturbances in the global economy

Week 2:2 12

A paradigm shift?Things had changed and the ‘old’ model was no longer fit

for purpose

In the 1950s and 1960s Rebuilding after the war Exchange rates were pegged to the dollar, giving stability UK inflation was tied to global inflation which was largely

determined by US macro policy – at the time, very conservative

The Korean War had just finished which led to a decline in global commodity prices

This was partly due to the new floating exchange rate system....

Week 2:2 13

(1) Floating exchange rates

In effect, it reversed the role of monetary and fiscal policyThe government now needed to intervene in currency

markets...fiscal policy without monetary policy would be ineffective because interest rates and exchange rates would change

“It was perhaps as much the transition to floating exchange rates as the blandishments of Milton Friedman that caused governments to become monetarists”, Maynard, 1989, p.11

A decline in ‘money illusion’ (real versus nominal prices)

Inflation changed real relationships...the relationship between real consumption and real income changed in EuropeConsumption function shift

Week 2:2 14

(1) Floating exchange rates

The UK Government probably didn’t appreciate all this at the timeA reluctance to use interest rates as a policy toolA commitment to full employment

There was in part a belief that the Balance of Payments had ‘held Britain back’ in the 1960s, but when free of the international monetary system, the economic growth was not unleashed

SUPPLY SIDE PROBLEMS??

Week 2:2 15

(2) Relative prices were distortedYes there had been the oil shock

BUT the UK had its own problems

For YEARS we had been experiencing a downward trend in the return on capital employed (ROCE – a measure of profitability) Fell by >75% 1960s to 1970s Partly due to oil Not down to competitiveness – Unit labour costs

improved by 15% 1965-1975...

The ratio of capital to labour was increasing faster than the rate of productivity

Week 2:2 16

Why?Labour was becoming a less attractive input

In part because of years of capital subsidies, designed to stimulate growth (“Going for Growth” Policy) and create full employment

In part a function of the incomes policies and the anticipatory wage demands and comparatively strong trade unions

It didn’t really manifest itself through decline in employment because of the absorption of employment by the public sector

Week 2:2 17

UK Productivity growth

Table 1.3 Productivity of labour and capital in the UK (compound annual growth rates)1960s 1969-79 1979-82

Labour productivity 5.8 2.2 3.5Capital productivity 1.1 -2.6 -4.4Total Factor Productivity 4.9 1.1 1.6Source: Maynard, from OECD Economic Outlook, May 1986.

Q=f(L, K, M)

Week 2:2 18

In summary...The post-war period, though stable, is regarded

by many as a missed opportunity

Things changed as a result of the oil crisis and the move to floating exchange rates

The UK was also affected by the relative prices of inputs

Week 2:2 19

Next week...Friedman and the growth of monetarism

The rise of Thatcherism

The start of the ‘Great Moderation’

The productivity miracle

Week 2:2 20

ReferencesGriffiths and Wall (2009) Applied Economics 9th Edition,

chapter 24 .

Maynard, G. (1989) The Economy under Thatcher, Blackwell, London Chapter 1.