The Philips Curve
From Biz-ed Philips Curve
The Philips curve shows the relation between inflation and the Unemployment rate saying as unemployment is low inflation is high,conversely as unemployment is high inflation is low. Two of the main macroeconomic objectives low inflation and unemployment had been said to be mutually exclusive- meaning a TRADE OFF.
However it has been said that there was a break down of the Philips curve in the 1970s because there was a period of stagflation where there were both high levels of inflation and unemployment.
Monetarist economists, like the American Milton Friedman had said that the short run Philips curve was applicable but in the long run there was no such trade off because unemployment would always be at Natural Rate of Unemployment. This had said to be impossible to reduce unless there was ever accelerating unanticipated inflation.
The Original Philips Curve had said that it wrongly took in account of the current rate of inflation but not the expected rate. So this is where the Expectations Augmented Philips Curve comes in as it does this.
This is as people would normally tend to form expectations of future inflation on the basis of the current rate of inflation. So it starts with 0 the future will tend to be 0% however if the government tries to stimulate aggregate demand it be a different case. Lets AD increases leading to a 5% inflation. In the short run the original Philips curve does show a trade off as unemployment shifts from A to B from the diagram above shown. However it is not sustainable as for workers to supply more labour the real wage must rise however in the short run they are suffering from money illusion. However in the long run they realise this and get off money illusion and realise their wage is not rising as fast its cost. So they decide not to supply their labour unless their wage actually increases in real terms. So therefore move to point C where there is a new short run philips curve and it is still on the long run philips curve but at a higher inflation.
In order to tackle natural rate of unemployment supply side reforms are needed
Supply Side Policies are policies aiming to influence aggregate supply( total output of the economy) hence the long run aggregate supply curve shifting to the right. Additionally these policies would encourage growth without a rise in the price level. They are largely microeconomic and fiscal in nature.
Supply side policies can be split into both Labour and Product Market measures
Labour Market Measures:
1) Lower Rates of Income Tax- so there would be greater incentives to work such as people have more disposable income, therefore they would try to maximise this.
Supply Side Economists use the Laffer Curve to show that high income tax rates and high burden due to tax cause disincentives to work.
From Google Images Laffer Curve
Structured by supply side economist Arthur Laffer it shows the relationship between tax rates and tax revenues. Tax revenues is 0% at both when tax rate is 0 and 100%. Tax revenue is of course 0 when tax rate is 0%. However why at 100%? This is because att a 100% it means all income is tax therefore there is incentive to work at all so the government would not get any tax revenue at first. Tax Revenue is said to be at its peak at 50% however after that it was simply decrease as it be no incentive for the firm to work.
2) Reducing Welfare Benefits and the benefits to work- If benefits are harder to claim it may give people an incentive to find a job( mostly low paid) rather than claiming these benefits. This woudl include employment programmes such as Welfare to Work.
3) Education and Training- Increasing educational attainment and training have effect on productivity of labour in this nation and therefore help to enlarge the supply capacity. There are many training agencies and City Technology Colleges that would help to develop vocational and technical education.
4) Trade Union Reforms
Product Market Measures
These measures would help to increase competition and efficiency of certain industries as if productivity increases overall this would mean more can be produced with the given amount of resources. Therefore a shift in the long run AS curve.
Measures would include :
- Deregulation of markets where there is less barriers of entry encouraging more competition
- Privatisation of some firms
- Tough competition policy
- Measures to encourage entrepreneurship and capital spending such as guarantees for start ups
- less corporation tax for businesses
- tax relief on capital spending
- regional policy assistance in depressed areas.
From Google Images, PPF Curve
from google images, LRAS Curve Shift to the right
The benefits of Supply Side Policies
- Sustained Growth
- Decrease in prices
- Improvement in Balance of Payments
- Job Creation
Evaluating Supply Side Policies
- Supply Side Policies would contain long time lags; these problems regarding unemployment have been around a long time has there already been policies to tackle but not taken any effect?
- So could there be a need for both demand and supply side policies. Whereas demand side is used to stimulate growth while supply side is used to sustain growth
- Distribution? Some policies like the reduction of income tax can widen the gap between the richest and the poorest ? The supply side policies may be narrowly aiming at certain firms i.e. small firms and therefore overall might not make much affect while money could have gone to projects that have a bigger effect
- It says it improves gdp without increasing price, supply side might have demand side effects – in future cause inflation? LONG TERM consequences aswell?
- Supply side policies may not be enough to make signifcant progress to macroeconomic objectives so more than one policy may have to be used with a mutually reinforcing effect such as supply side policies to help increase innovation but also policies to help cut down carbon emissions.
(05) Extract D( lines 1-2) refers to EU governments spending their way out of recession.
Explain the term ‘spending their way out of recession’ and analyse two reasons for government spending other than to influence the economic cycle.
Spending their way out of recession means there is expenditure by the government in order to help increase aggregate demand which is the total spending in the economy. This can be shown by the diagram where price level increases from r0 to r1 while output increases from yo to y1.
from google images
This could be spending on new infrastructure such as roads, hospitals and this would mean an injection to the circular flow of income. This could lead to a multiplier effect whereas an there is a bigger proportional increase in GDP than what is put in for example there could be the creation of new jobs due to this spending therefore leading to more spending from people in these jobs. This spending will carry on and overall the country benefits potentially be out of recession.
Another reason why there is government spending other than influencing the economic cycle would be government would want to spend to help alleviate such as welfare benefits and job seeker’s allowance where people would have a chance for a higher income, extremely important for people who are disabled and cannot find a job.
Additionally the government may spend money on supply side reforms such as education and training and help them to be introduced and developed which can help the economic cycle but that is in the long term. Supply side reforms like training could help people have better prospects when trying to find a new job, they could apply for higher skilled jobs. This can also help people alleviate from poverty and reduce the number of people in long term poverty. Attempting to help improve the standard of living of some households.
In order to become an economic union the EU itself needed to create a common currency. Therefore there also had to be a monetary union which number of elements included:
- A single currency used by all participants, the euro and operates in the FOREX market as a managed float.
- An independent central bank which regulates the rate of interest and monetary policy
- A stability and growth pact that limits the public sector borrowing of the participating countries to 3% if GDP so stop frustrating the monetary policy used by the ECB.
So what are the potential benefits of a single currency:
- Reduced Transaction Costs- the cost of changing from one currency was gone meaning countries could potentially gain more GDP- it was said average 0.4% more
- Reduced exchange rate uncertainty- this allows for businesses to trade more and also more investment within these countries.
- Increase competition
- Increased foreign direct investment
- Lower interest rates
Potential Costs of a single currency
- LOSS OF AUTONOMY OF FINANCIAL SERVICES: Loss of an independent monetary policy– one size fits all policy as the interest rates would be the same for the whole eurozone area and it isn’t very suitable as not every country is at the same stages. Some may need lower interest rates to stimulate growth some may need higher to restrict growth.
- Not Optimal Currency area whereas it is said people can move easily however there are barriers in terms of language unlike USA where someone from New York could move to New England
- Limits Fiscal Policy– the growth and the stability pact had restricted countries spending otherwise they would be in debt.
- Lack of Incentives– it was said that once a country was part of this single currency they would be protected from currency crisis however this was not the case- e.g. Greece.
- Lack of devaluation to make goods more competitive
The Eurozone Crisis had started since 2008/2009 where there was a fatal flaw that was part of the eurozone. This had included that in order for a monetary policy and the single currency to work there had to be centralised political control and a fiscal policy are required. This is as a policy is needed in order for countries like Greece not to be spending too much running up huge budget deficits and borrowing far too much.
Additionally there had been said to be a division between countries of the Eurozone where not all the money had been distributed fairly and that is why a common fiscal policy is needed in order to redistribute some of the wealth of the richer members of the monetary union. However the Eurozone itself had not met any of these requirements leading to the breakdown of the eurozone.
The European Union is a political and an economic area that consists of 27 member states that are located primarily in Europe.
- The UK joined the EU in 1973 after previously been part of the EFTA which was the European Free Trade Area.
The EU institutional structure would be :
- The Council of Ministers
- The Commission- this is the institution that represents of the EU as a whole and is responsible for the EU laws and policies are carried out.
- The European Parliament
- The Court of Justice of the European Community
- The European Central Bank- central bank for the single currency the Euro used by 16 of their member countries.
The Single Market: This occurs when the member countries act as one single economic area with the free flow of goods, services, capital, labour. It came in operation in 1992.
Benefits of the Single Market:
- Economies of Scale – with the 480 million consumers in 27 countries it is possible for the countries to take advantage of higher output and also lower costs. This would lead to greater efficiency of the market in terms of allocation and productivity.
- Increased Dynamic Efficiency– Due to greater competition between between different countries this has encouraged more innovation , reduction in monopoly market. Leading consumers having more choice.
- increased liberalisation ( less government regulation leading to more competition) – The allowing of cheaper airlines like Ryanair, Easyjet to form and they have had cheaper costs such as electricity due to the signle market.
- Business there has been a significant reduction in export burreaucracy as open borders cut delivery times and reduce costs. Single Market is a domestic market for a European Business.
- UK Citizens are allowed to work, retire in all other member states.
- Some businesses might lose out due to the increase competition because they haven’t established in the market yet. Therefore they cannot compete with the existing firms and adversely causing a loss of jobs.
- The Single Market is still a work in progress whereas there are gaps remaining in areas such as intellectual property rights, services, retail financial services.
- Service sector has opened slower compared to goods even though there has been new goods. It has not increased competition to an extent. Additionally with some markets such as financial, transportation, utilities still holding a huge deal of monopoly power.
Expansion of the EU
In 1993 it was agreed that the Central and Eastern European countries could join- 12 more countries mainly from Eastern side had joined. This was seen beneficial for UK as:
- The single market has expanded and the UK has seen the increase of free market size is good as there be more trade.
- These countries have low taxes which encourage economic development and are allies of the Anglo Saxon Neo Liberalism.
- France and Germany were seen to have a lot of power and these new countries could potentially counterract this power.
EU10( the 10 Eastern European Countries);How have they affected the EU?
- The population had increased by 100 million
- Only added 5% to the overall GDP
- Lead to increased migration for countries without restriction,
- Lead to new constitution so decision making would not be made slower.
From Bized – J curve effect
This is to do with the policies to reduce the balance of payments deficit and hopefully get it into a surplus for the future. ‘Depreciation’ is an example of a expenditure switching policy( policies to help influence the change of exports increasing imports decreasing)
The J Curve effect shows what happens to the Balance of Payments when there is a depreciation.
This can be split into both short and long run. From the Marshall Lerner condition if the elasticities of exports and imports are more than 1, a depreciation would lead to an improvement in the balance of payments. Likewise if the elasticities were less than 1 depreciation would lead to a deteriotion.
Short Run: Lets say there is already a deficit and there is a depreciation in our currency
- Normally a depreciation would mean exports go up and imports go down.
- However due to the change it would take consumers time to firstly know about the price changes and time to act on it i.e. find substitutes.
- There the price elasticities of both exports and imports are less than 1. Therefore a depreciation leads to the worsening of the balance of payments as shown by the diagram.
- However over time people would realise that the foreign goods would be more expensive than domestic goods.
- So they would tend to reduce their consumption on imports and increase on domestic goods. Our price elasticity for both export and imports is now greater than 1.
- Therefore we would see a rise in our balance of account and hopefully reach a surplus as shown by the diagram.
However the question is what will happen next? The answer is it is likely to fall again as our exports will be in higher demand leading to an appreciation in our currency due to more demand. So this could potentially mean less exports and more imports in the future.
06- Lines 35-36 argues that a more ambitious set of common macroeconomic policies would help speed recovery in the UK
Using the data and your economic knowledge, assess the impact on the UK economy of a recovery in the EU as a whole.
Introduction and Development
- EU recovery – meaning countries in the Eurozone have gotten out of their economic decline to show some signs of growth.
- This could impact the UK aswell as they are part of the eurozone. Can help them in several ways
Point 1- Trade leading to multiplier effect
- As other countries recover this could mean there could be increase trade around the EU.
- This would be a positive impact for the UK as this could mean more exports could be sold therefore this would lead to an injection in the circular flow of income.
- as exports is part of aggregate demand ( def) leading to potential economic growth.
- Therefore could potentially lead to a multiplier effect—> increasing employment, and overall the confidence of people after a long financial crisis.
- Depends on the extent of recovery as it could only be a small margin 0.1% growth which might make little difference
- There has been a wider divide between the more developed and the less developed in the EU and the smaller countries might have not recovered but instead declined. So this might dampen down some of the UK’s trading potential with these countries.
Point 2- Balance of Payments on Current Account improved
- As said exports would be likely improve as trade would tend to increase between these countries due to these increase in confidence.
- A weaker pound would help as the recession most likely had meant there was a decrease in demand for sterling leading to a depreciation making our exports cheaper.
- Depends on elasticity of our goods- are they better than German or French goods in terms of quality?
- How fast is the recovery if there is a slow recovery countries from the EU still have their people not confident.
- As there is appreciation due to potential greater demand for our this might affect firms who have their raw materials imported have their costs increase in price.
- Overall we have to consider how fast the recovery and how much has it recovered. Has it just recovered little margins from a long recession.
- However if there was sustained recovery it would benefit the UK in terms of trade leading to aggregate demand increase so a potential growth our economy.
- This would lead to an multiplier effect.