D217 Essential Economics - Macro Perspectives PDF

D217 Essential economics Book 1 Macro perspectives This publication forms part of the Open University module D217 Essential economics. Details of this and other Open University modules can be obtained from Student Recruitment, The Open University, PO Box 197, Milton Keynes MK7 6BJ, United Kingdom...

D217 Essential economics Book 1 Macro perspectives This publication forms part of the Open University module D217 Essential economics. Details of this and other Open University modules can be obtained from Student Recruitment, The Open University, PO Box 197, Milton Keynes MK7 6BJ, United Kingdom (tel. +44 (0)300 303 5303; email [email protected]). Alternatively, you may visit the Open University website at www.open.ac.uk where you can learn more about the wide range of modules and packs offered at all levels by The Open University. The Open University, Walton Hall, Milton Keynes MK7 6AA First published 2023 Unless otherwise stated, copyright © 2023 The Open University, all rights reserved. All rights reserved. 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ISBN 978 1 4730 3512 6 1.1 Preface v Part 1 Chapter 1 Crises: causes and effects 1 Jonquil Lowe and Cristina Santos Chapter 2 The interconnected world 55 Lorraine Mitchell Part 2 Chapter 3 Keynes and unemployment 111 Andrew Trigg Chapter 4 Fiscal policy 161 Andrew Trigg Chapter 5 Money and investment 207 Jonquil Lowe Chapter 6 Monetary policy 257 Jonquil Lowe Part 3 Chapter 7 From aggregate demand to managing inflation 309 Teresa Ashe Chapter 8 Monetary policy in action 365 Jonquil Lowe Chapter 9 How robust is the inflation-targeting model? 419 Ayobami Ilori Chapter 10 Macroeconomic policy in the long run 475 Julia Ngozi Chukwuma Glossary 527 Index 541 Acknowledgements 555 Preface The first quarter of the twenty-first century has seen a staggering parade of economic crises that have made it ever more important to understand the essentials of economics. In 2020, the global COVID-19 pandemic closed down economies all over the world. This crisis hit at a time when governments were still coping with the after-effects of the 2008 Global Financial Crisis – in particular, increased levels of inequality between rich and poor – that heightened questions about the ethics of capitalism and historically large amounts of public and private debt. In February 2022, before the global economy had been able to recover from the most acute phase of the pandemic and when it was already struggling with growing price inflation, Russia launched a war on Ukraine, therefore fanning the flames of a global energy crisis and causing wider economic and financial disruption. Furthermore, these events have been happening against the unfolding climate crisis, which has yet to be addressed with sufficient urgency and scale. The 2008 Crisis was particularly notable for the discipline of economics because it triggered a heated debate among economists about the appropriate policy responses to achieve economic recovery and restore government finances. It also called into question the very tenets of economics, as its practitioners had mostly failed to identify the instabilities building up within the system and so were taken by surprise when the crisis hit. Among the more welcome developments in its aftermath have been an increased interest in the study of economics, and a greater recognition of the importance of economic pluralism (schools of thought beyond the mainstream, largely neoclassical, ideas that have underpinned the approach of many policymakers since the late-1970s). This has spurred interest in different ways of teaching and studying economics. D217 Essential economics: macro and micro perspectives are the core texts for an Open University (OU) module. The module is aimed at undergraduate students studying the subject within a named economics degree or within multi-disciplinary and interdisciplinary degree programmes, such as social science and business. The two texts are Book 1: Essential economics: macro perspectives and Book 2: Essential economics: micro perspectives. These two books provide an introduction to, and intermediate development of, this fascinating, at times controversial, and important discipline. They teach both the mainstream theories that are still central to policy-making and business v  decision-making, but they also introduce you to ideas from some of the competing schools of thought that make up the economic pluralism for which the OU has, from its inception, been renowned. Drawing, for example, on Keynesian, post-Keynesian and ecological economics, the topics, ideas and theories covered have been selected – as the title suggests – because they are essential to a wider understanding of the world in which we all live and hope to thrive. The perspective is global, including the Global South, with a deliberate aim of contributing towards the decolonisation of the economics curriculum. Along the way, the books gently introduce you to basic modelling and quantitative techniques, such as understanding diagrams and constructing indexes, which are part of the economist’s essential toolkit. D217 Essential economics is innovative in focusing first on macroeconomics, guiding you through the historical roots and relative merits of Keynesian fiscal policy and a range of contemporary monetary approaches to policy-making. Should governments, for example, spend their way out of a crisis; and how can they control inflation? Book 1 teaches you first how to read macroeconomic indicators, tracing the path of economies through crises over the decades. The book moves on to using economic models to understand what is going on in an economy and the impact of policy interventions. An introduction to Keynesian aggregate demand analysis is followed by an examination of an inflation-targeting model that develops your understanding of both conventional and unconventional monetary policies. Book 2 drills down beneath the macro-picture to explore the decision- making processes within the firms that drive the economic growth of an economy, but pose critical challenges for regulation, social policy and the ecology of the planet. You develop an understanding of traditional approaches to the theory of the firm and the working of markets, with particular emphasis on how to regulate companies that wield too much power in an international economy. You will explore issues related to free trade and protectionism, in Europe and beyond. Moreover, this book examines policies that aim to moderate and offset the negative outcomes of market-driven economies, which left unfettered create stark inequalities between rich and poor both within and between countries across the globe, and have had such disastrous consequences for the environment. vi Three key themes run through the books and module. These are: l Fragility: this theme acknowledges that we inevitably live with change and uncertainty. Fragility embraces many aspects of economics. For example, neoclassical economics assumes that economies, left alone, tend towards a beneficial equilibrium. In contrast, most branches of pluralist economics see this view of the world as unrealistic, in part because the system may not be self- correcting and can even collapse without intervention, but also because the neoclassical focus is irresponsibly narrow. For example, the 1930s Great Depression showed that reliance on markets could result in mass unemployment and human suffering. More recently, the 2008 Global Financial Crisis triggered renewed and widespread recognition that innovative but risky financial products can be a source of economic instability. The climate crisis is a further example of fragility, throwing into stark relief the wider destabilising effects of everyday human economic activity. l Economic justice: this theme concerns the way that the outputs from economic activity are shared both within individual economies and between nations. It is widely accepted that a capitalist system inherently distributes income and output unequally, creating societies where swathes of households struggling to meet their daily needs coexist with a small minority who are accumulating staggering wealth. Moreover, the damage from capitalism’s unintended side effects, such as pollution and global warming, falls disproportionately on countries that are not the main perpetrators. Economic justice looks for ways to address such inequalities either at source or through redistribution and compensation. l Policy intervention: if the first two themes sound a little bleak, this third key theme examines what those with power can do to moderate and counteract fragility and economic injustice. While power is often vested in national governments and vast multinational corporations, the module examines the viability of international cooperation and opportunities for businesses, social movements and individuals to exert their agency to achieve greater security and justice. The themes help to highlight the challenges and options that economic agents – whether households, firms or governments – face. The themes also provide a framework for understanding that the tools of economics are essential aids if all of us, as members of our local, vii  national and global society, are to make sound decisions for the well- being of ourselves and future generations. Contributors Academic editors Jonquil Lowe, Senior Lecturer in Economics and Personal Finance, The Open University Dr Roberto Simonetti, Senior Lecturer in Economics, The Open University Professor Andrew Trigg, Professor of Economics, The Open University Authors Dr Teresa Ashe, Staff Tutor, The Open University Dr Julia Ngozi Chukwuma , Lecturer in Economics, The Open University Dr Alison Green, Staff Tutor, The Open University Dr Martin Higginson, Senior Lecturer in Economics and Staff Tutor, The Open University Dr Ayobami Ilori, Lecturer in Economics and Staff Tutor, The Open University Jonquil Lowe, Senior Lecturer in Economics and Personal Finance, The Open University Professor Maureen Mackintosh, Emeritus Professor of Economics, The Open University Dr Lorraine Mitchell, Lecturer in Economics, University of Kent (previously Lecturer in Economics, The Open University) Dr Baseerit Nissah, Lecturer in Economics and Staff Tutor, The Open University Dr Stuart Parris, Senior Lecturer in Economics, The Open University Dr Carol Patrick, Associate Lecturer in Economics, The Open University viii Dr Cristina Santos, Lecturer in Economics, The Open University Dr Roberto Simonetti, Senior Lecturer in Economics, The Open University Dr Gary Slater, Associate Professor in Economics, Leeds University Business School Professor Andrew Trigg, Professor of Economics, The Open University External academic assessor Dr Sara Gorgoni, Associate Professor in Economics, University of Greenwich Personal acknowledgements Like all teaching materials produced by The Open University, the module is a product of collective working. The authoring team includes academics from The Open University and outside institutions. The module team also includes many essential contributors whose outstanding professional expertise has made it possible for this module to exist. They include our curriculum manager, curriculum assistant, production and presentation manager, project manager, publishing editors, designers and artists, software designers, production assistant, indexer, learning and teaching librarian, accessibility experts, sound and vision producers, and colleagues in online services, visual resources and copyright clearance. Special thanks are due to our external assessor, Sara Gorgoni, who has offered valuable advice and support throughout the process. Similarly, the finished module has been much improved through the incisive feedback from our reviewers: Harriet Gregory (student reviewer), Oana Tanasache (equality, diversity and inclusion reviewer), and Alberto Zanni and Nick Potts (tutor reviewers). We are enormously grateful to all the participants who have contributed to the module with their invaluable expertise and generous effort. Jonquil Lowe, Module Team Chair Andrew Trigg, Module Team Chair 2023 viiii Part 1 Chapter 1 Crises: causes and effects Jonquil Lowe and Cristina Santos Contents 1 Introduction 5 2 What is an economic crisis? 8 2.1 Measuring economic activity 9 2.2 Visualising economic activity 12 2.3 Why crises matter: unemployment 16 3 Why do crises happen? 22 3.1 External shocks 22 3.2 The Keynesian Revolution 24 3.3 Fragility within the economy 25 4 Inflation and deflation as crises 34 4.1 Measuring inflation 35 4.2 Why inflation matters 39 4.3 Why deflation matters 41 5 Climate change as an economic crisis 43 6 Conclusion 47 Answers to activities 48 References 51  1 Introduction 1 Introduction In late 2019, Chinese authorities began investigating 27 unexplained cases of viral pneumonia in the city of Wuhan that looked similar to a highly infectious and deadly outbreak some years earlier (Deutsche Welle, 2019). Despite attempts to contain the outbreak, the virus rapidly spread worldwide and by 11 March 2020 the World Health Organization (WHO) had declared a global pandemic – the first ever to be caused by a coronavirus, which WHO named COVID-19 (WHO, 2020). Delhi in 2019 and 2020: air pollution dropped as economies locked down 5 Chapter 1 Crises: causes and effects The measures that governments deployed to stop the spread of COVID-19 were extraordinary outside times of war. They included laws to enforce social distancing, mandatory wearing of face masks, curfews and ‘lockdowns’ during which citizens were severely restricted or banned from leaving their homes, while schools and non-essential businesses were shut down. By April 2020, four billion people, half of the world’s population across 90 countries, were under some form of lockdown (Sandford et al., 2020; UN, 2022). As a result, economies around the world tumbled into the deepest recession since the Great Depression of the 1930s (IMF, 2020). The 1930s crisis was characterised by years of falling output, bankruptcies, mass unemployment and poverty. The 2020 COVID-19 crisis could have been similar except, over the intervening years, many governments had changed their approach to managing economic crises. This time, they took swift action to protect their citizens against job and income loss and to prevent businesses from failing. An unexpected side effect of the steep drop in economic activity and transportation caused by lockdowns was a sudden improvement in air quality in cities; for example, Delhi in India. With some irony, it was suggested that the pandemic interventions offered a foretaste of tackling the other great challenge of our time: the climate crisis. In Book 1 Essential economics: macro perspectives you will explore how the decisions of firms, households and governments can determine whether an economy maintains a placid course, experiences rapid growth or spirals into crisis. In Part 1 you start by considering what it means for an economy to be in crisis and how nations’ trading and financial ties create an interconnected global economy that can quickly transmit economic fortune and misfortune from one country to another. Chapter 1 looks at some significant economic crises and introduces you to the main economic indicators used to monitor a nation’s economy, a simple diagram for describing macroeconomic relationships and some theories that help in understanding why crises happen. 6  1 Introduction The learning outcomes for this chapter are to: l be confident using key economic concepts, such as indicators, growth, recession and crisis l be able to explain the concepts of unemployment rate and inflation rate, and understand the way they are measured l read and interpret macroeconomic data presented in different ways l use a simple diagram to represent some key economic relationships l begin to understand the role of the financial sector in the economy. 7 Chapter 1 Crises: causes and effects 2 What is an economic crisis? Signs of recession Business cycle An economy can be thought of as an arena for the provision, Repeated phases of allocation and use of resources. Within this arena, interactions between high and low growth. millions of producers and consumers take place, making it hardly surprising that the level of economic activity is continuously fluctuating. Some of these fluctuations seem to take the form of repeated ups and downs, called the business cycle. Governments may choose to use their economic policy tools (such as benefits for the Agents unemployed) in quite an automatic way to smooth out the peaks and Individuals, groups or troughs of the business cycle. However, these ups and downs, while organisations that make having an impact on economic agents, are a normal feature of a economic decisions. complex economic system, and they do not in themselves represent a Recession crisis. Technically defined as a decline in total output At times, however, a peak or trough in the business cycle may become (GDP) for a period of excessive, or the economy may be thrown off course by a totally two quarters or more. unexpected shock. In either case, this may tip the economy into a Depression recession. If a recession is particularly deep or persistent, it is A period of prolonged sometimes called a depression. All depressions and some recessions, and severe recession. particularly those which are abrupt or prolonged, are judged to be crises. A crisis usually requires a policy response that is abnormal in its scale and/or type. 8  2 What is an economic crisis? 2.1 Measuring economic activity When economists and politicians talk about economic activity and Gross domestic growth, they are usually referring to the total output of the economy as product (GDP) measured by gross domestic product (GDP). This is intended to be A measure of the size of a country’s the value of everything the economy produces or, looked at from a economic activity different but equivalent angle, the value of all the incomes that the generated during a economy’s agents receive – you will see why this is so in Section 2.2. specific period of time. It can be measured as the total output, total income or total Box 1.1 A note about stocks and flows expenditure of an Confusingly, sometimes countries with a high GDP are called the economy during that ‘wealthiest’ nations. However, GDP is not a measure of wealth; it period. is a measure of income. The distinction is important: income is a flow over time; wealth is a stock, meaning an accumulation of assets at a point in time. Flow The movement of GDP, the flow of a country’s output (income) over a year, a income or goods and quarter or some other time period is a widely used metric in services between economics. A nation’s total wealth (its stock of assets, such as sectors that occurs housing stock, value of its road and rail infrastructure, and so within a specified on) is seldom used and difficult to measure. period of time (such as a year or a quarter). Conventionally, continually rising GDP – in other words, economic Stock growth – is taken to be a measure of success. Growth is calculated as The total amount of the percentage change in GDP. GDP growth rates are usually capital, savings or some calculated quarterly or annually. If an economy is growing, the GDP other quantity at a given moment in time. growth rate is positive. If the growth rate is negative, the economy is The size of a stock contracting and may even have entered a recession (two or more changes if there is a consecutive quarters of falling output). net inflow or outflow (e.g. of investment or Figure 1.1 shows the annual GDP growth rates for all the countries in saving). the world from 1961–2021, divided into groups according to income per capita (‘per capita’ means divided by the number of people in the Assets population) (World Bank, 2022). Stocks of accumulated The figure uses a device called ‘stacked charts’: each chart has its own wealth owned by firms, households or vertical axis showing the GDP growth rate, but they share the governments. horizontal axis from 1961–2021, so you can easily compare the pattern of the different income groups over time. The shaded areas highlight periods that are deemed to have been global economic crises: for example, the OAPEC (Organization of Arab Petroleum Exporting Countries) oil crisis in 1975 (Kose and Ohnsorge, 2020). 9 Chapter 1 Crises: causes and effects GDP growth rate % a year High-income countries 10 0 -10 GDP growth rate % a year Upper-middle-income countries 10 0 -10 GDP growth rate % a year Lower-middle-income countries 10 0 -10 GDP growth rate % a year Low-income countries 10 0 -10 61 71 81 91 01 11 21 19 19 19 19 20 20 20 1975: OAPEC oil crisis 1982: oil price rise, tight monetary policies, Latin America debt crisis 1991: Gulf War, oil price rise 2009: aftermath of Global Financial Crisis 2020: COVID-19 pandemic 2021-22: Gas price rise, Ukraine war Figure 1.1 Worldwide annual GDP growth rates, 1961–2021 (data from World Bank, 2022) 10  2 What is an economic crisis? Notes for Figure 1.1: OAPEC countries are part of the upper-middle-income countries group; GDP is in ‘real terms’, meaning that it reflects changes in the volume of production and not variations due to price changes. Activity 1.1 Crises differ Allow 15 minutes for this activity Using Figure 1.1, answer the following questions: 1 What sort of events are associated with the crises shown in the figure? 2 Were all countries affected by the 2008 Global Financial Crisis? Answer 1 You can see from Figure 1.1 that three types of event are particularly associated with global crises: disruption in energy markets; wars; and various types of financial crisis, for example, problems repaying national debts or the collapse of asset prices. 2 Despite its name, the 2008 Global Financial Crisis seems to have affected mainly high- and upper-middle-income countries. However, there is a dip in low-income countries’ GDP below 0% in 2012. This was a knock-on effect of the crisis because wealthier countries cut their trade, investment and aid to lower-income countries (IMF, 2009; OECD, 2012). Because of the way countries’ economic activities are interconnected, there is much potential for events in one part of the world to have a global impact. But, as you will see in Chapter 2, a crisis for one country may benefit another while passing other nations by. In order to take a closer look at evidence of crises and their consequences, it is necessary to look at country-level data rather than global figures. This chapter will take the United Kingdom (UK) as an example. 11 Chapter 1 Crises: causes and effects 2.2 Visualising economic activity Model Economic activity can be represented with a diagrammatic model A purposefully widely used in macroeconomics: the circular flow of income simplified diagram. It illustrates how income, spending and output flow around representation of the economy and demonstrates how heavily they are interrelated. The reality. circular flow of income also helps to visualise how GDP can be Circular flow of measured from any of three perspectives: income, spending and income diagram output. A diagram illustrating the exchange of goods, To demonstrate the idea, Figure 1.2 shows a circular flow of income services and money diagram for a very basic economy in which there are just two kinds of within the economy. economic agents: firms and households. To keep the analysis simple, Closed economy Figure 1.2 represents a closed economy, meaning one that does not An economy where interact at all with other countries. The economy also has no agents (such as government and no financial sector. households and firms) trade with each other but do not interact with agents in other countries. Rent, wages, profit and interest (income) Households Land, labour and capital (factors of production) Goods and services (output) Firms Spending on goods and services (expenditure) Figure 1.2 The circular flow of income in a closed economy without government and financial sectors 12  2 What is an economic crisis? In the simple economy shown in Figure 1.2, it is assumed that households own all the resources used by firms to produce goods and services (output). These resources are commonly called factors of Factors of production production and are often divided into three categories: land, labour The inputs of land, and capital. Households are assumed to sell these factors of production labour and capital used by firms to engage in to firms in return for income, which takes the form of rents for land, production. wages for labour, and profits and interest for capital. Households use their income to finance the consumption of goods and services which they buy from the firms. Box 1.2 Factors of production As a starting point, it is convenient to think of output as being the result of combining three factors of production: land (including all the resources it offers, such as fossil fuels, forestry and crops), labour and capital. However, this approach – associated with neoclassical economics – is somewhat Neoclassical ambiguous and controversial. economics A school of thought For example, capital means the tools and machinery used in that originated in the production when considering the output that it generates, but late 1800s, and remains simultaneously it is assumed to be the finance that can buy dominant today, which those physical items when thinking about the income paid to the analyses economic owners of the factors of production (Robinson, 1953). issues with an emphasis on demand and supply The aim is not to confuse you at this early stage of your studies, driven by rational self- but to alert you to the contested nature of many of the seemingly interested consumers innocuous foundations of economics as traditionally taught. An who maximise their essential part of your economist’s toolkit is to be open to utility (satisfaction) and different perspectives as your understanding deepens. by profit-maximising firms. Figure 1.2 focuses on the flows between households and firms. The top of the figure shows the flow of the factors of production from households to firms (inner line) and the corresponding flow of income from firms to households (outer line). The flow of goods and services from firms to households is shown in the bottom of the figure (inner line) along with the corresponding flow of expenditure from households to firms (outer line). The two inner lines represent the flows of physical items between households and firms – goods and services, and the factors of production – while the two outer lines show the flows of money. In this simple economy, all money that is earned is spent. For example, if 13 Chapter 1 Crises: causes and effects income totals £1 trillion a year, then spending also equals £1 trillion a year. Therefore, the level of activity in this economy can be assessed by measuring all the income, all the expenditure or (the value of) all the output. Even in a more complex economy, with appropriate adjustments (for example, for government and international flows), the same three approaches can be used to measure its GDP: l Income approach: this involves adding up all the incomes received by households. The main source for this type of information is a country’s tax authority (such as HM Revenue & Customs in the UK). l Expenditure approach: this involves using sales data and surveys of expenditure to estimate total spending on domestically produced goods and services. Surveys are typically undertaken by a country’s statistics authority (such as the Office for National Statistics in the UK). l Output approach: the main source of this data is regular surveys of production. Broadly speaking, output is valued using the prices at which goods and services are sold. However, the output of one firm may be used as an input by another firm (called an intermediate good). To avoid double counting, the output approach measures just the value added. Intermediate good Figure 1.3 illustrates this idea of value added by taking the example of A good (or service) a pre-packed sandwich that you might buy at a supermarket. The figure which is the output of shows five producers involved in the process, with each one adding a firm and which is some value to the sandwich pack. Let’s consider the value added by the used as an input by another firm. baker. Each pack includes 10p worth of bread, but in order to make the bread the baker had to buy the flour (the baker’s intermediate Value added good) from the miller. This flour has an input price of 7p (which The additional value given by a firm to its comprises 5p of grain from the farmer and 2p of value added by the intermediate goods in miller). So, the baker has added 3p of value per sandwich producing its output at pack: each stage of production. 14  2 What is an economic crisis? 1 Farmer produces grain: 5p of grain goes into every sandwich pack Miller produces flour: 2 7p of flour goes into every sandwich pack 3 Baker produces bread: 10p of bread goes into every sandwich pack Caterer produces 4 sandwiches: 70p of sandwiches and packaging go into every pack 5 Supermarket sells sandwich pack for £1.60 £1.60 Figure 1.3 Transactions in the production of sandwich packs 15 Chapter 1 Crises: causes and effects Activity 1.2 Calculating value added Allow 15 minutes for this activity Using Figure 1.3, answer these questions: 1 What is the value added by the supermarket when it sells the pack of sandwiches? 2 By how much does each sandwich pack increase the output measure of GDP? The answers to this activity are at the end of the chapter. Having completed Activity 1.2, you may have been struck by some possible problems in using GDP as a measure of a country’s economic activity. For example: l Value added is based on the prices at which items are sold, but what if goods are over-priced – should the excess really be considered as ‘value’? l Why are unpaid services not included, such as family members (mostly women) caring for children and frail adults at home? Don’t these services have value too? l What about goods and services that have undesirable side effects such as pollution – how should they be valued? You will consider issues like these when you turn to the study of microeconomics in Book 2. 2.3 Why crises matter: unemployment You’ve seen that an economic crisis tends to be associated with a period of negative GDP growth, but why does that matter? The issue, as the circular flow of income diagram demonstrates, is that the level of output is directly related to income and spending. This means that if output falls, so do incomes and the amount that households can spend, resulting in declining living standards and rising poverty. The mechanism that brings about the reduction in income is typically unemployment, because, if output falls, firms will not require as much labour from households. 16  2 What is an economic crisis? Figure 1.4 shows the rate of UK unemployment (the dashed line) during the period 1971–2021. It also shows GDP growth for the UK economy (the solid line), and highlights five periods of recession (shaded areas). Some of these were global crises while others were domestic. For example: Inflation A general increase in l 1980–1981: Thatcher policies to reduce inflation – A Conservative prices over time that government led by Margaret Thatcher came to power in 1979 with raises the cost of living a manifesto that identified high inflation and militant trade unions in a country. as major problems facing the economy (Conservative Party, 1979). This government prioritised bringing down price inflation even at the cost of creating a recession. l 1991: UK exchange rate too high – The UK was trying to align itself with countries in the European Union (EU), resulting in economic measures unsuited to the UK. This caused the UK economy to contract. Before examining what the data in Figure 1.4 might reveal about Unemployment rate unemployment, it’s important to understand what is being measured. The proportion of a You’ve already gained some insights into the measurement of GDP, country’s labour force that is unemployed. but let’s pause a moment to think about what is being measured by the unemployment rate. There are several ways to calculate an unemployment rate. The UK – along with many other countries around the world – uses a standard metric defined by the International Labour Organization (ILO) (ILOSTAT, 2023). It relies on the following definitions: Labour force The combined total of l Labour force: this comprises people of working age, who are split those in employment into two groups: plus the unemployed. (a) in employment: this includes adults working for an employer for a wage or salary and self-employed people running their own businesses. (b) unemployed: to be in this category, a person must be out of work, either voluntarily or involuntarily, but actively seeking work. Unemployment is voluntary where someone chose to leave their work. Involuntary unemployment includes being fired or made redundant. 17 Chapter 1 Crises: causes and effects l Economically inactive: this group is not part of the labour force and covers people who are not working and not seeking work either from choice (perhaps having taken retirement), because they are doing unpaid work instead (such as bringing up children) or who cannot work because of health issues or studying (ONS, 2021). The unemployment rate is the number of unemployed people as a percentage of the labour force. (So, by definition, economically inactive people are not counted in the unemployment rate.) From a macroeconomic perspective, the unemployment rate can be seen as an indicator of the extent to which an important factor of production (labour) is being wasted, resulting in output being lower than it could potentially have been. It can also be viewed as an indicator of economic and social injustice since, at an individual level, unemployment is associated with reduced living standards, even poverty, and the loss of the psychological and social benefits that work often provides, such as self-esteem and companionship. The impact on mental well-being may be so severe that some workers shift to becoming long-term economically inactive, perversely reducing the official unemployment rate. Activity 1.3 Economic growth and unemployment Allow 15 minutes for this activity Looking at the data for the UK shown in Figure 1.4, do the patterns you see suggest a relationship between GDP growth and unemployment? Answer Unemployment might be expected to rise when GDP growth falls – this is called an ‘inverse relationship’. This seems to be what happened when the economy entered the 1980–1981, 1991 and 2008–2009 crises. However, a noticeable feature of the recessions which constituted those crises is that the unemployment rate did not start to fall again until some time after GDP growth had resumed. Interestingly, the unemployment rate did not rise much during the 2020 pandemic. 18  2 What is an economic crisis? GDP growth, % a year Unemployment rate, % of economically active 15 10 5 0 -5 -10 71 81 91 01 21 11 19 19 19 20 20 20 1974-5: OAPEC oil crisis 1980-81: Thatcher policies to reduce inflation 1991: Gulf War, oil price rise; UK exchange rate too high 2008-09: Global Financial Crisis 2020: COVID-19 pandemic GDP Unemployment Figure 1.4 UK GDP growth and the unemployment rate, 1971–2021 (data from Office for National Statistics, 2022a; Office for National Statistics, 2022b) Note: GDP is in ‘real terms’. An underlying relationship between macroeconomic indicators such as GDP growth and unemployment will not necessarily be obvious from charts like the one in Figure 1.4. This is because, as you have noted in Activity 1.3, there may be delays – called time lags – in the response of one variable to another. 19 Chapter 1 Crises: causes and effects In addition, there may be other factors influencing a variable – importantly, these include the impact of policy interventions. A striking example is provided by the only slight rise in unemployment in 2020 even though the economy tipped steeply into recession as a result of the COVID-19 crisis. The threat of mass redundancies and business failures could have scarred the UK economy for years; however, this was largely averted when the government used policy interventions to pump money directly into the economy. The main instruments were grants and favourable loans for business, while households received government money to replace their suspended earnings. Another problem in reading the data occurs when what seem to be well-established relationships between variables suddenly break down. This may be due, for example, to a change in the political regime. Unemployment in the UK was generally low during the period from the end of the Second World War (1945) up to the 1970s. You can see in Figure 1.4 that unemployment then shifted to much higher levels for a period of around 15 years due to the policy changes introduced by the Thatcher government during the 1980s. Gig economy working may hide under-employment 20  2 What is an economic crisis? Since the early 1990s, the unemployment rate has shifted to lower levels. Many reasons have been suggested for this (although there is no consensus). These reasons include, for example: l Weak employment laws which mean that UK firms are willing to take on employees, knowing that it is not too difficult to shed them again if the economy hits a downturn (The Economist, 2018). l A rise in more precarious forms of working, such as self- employment, zero-hours contracts (where employees have no promise of the number of hours of paid work they will be offered each week) and the gig economy (where workers, such as drivers and software developers, pick up one-off tasks and short-term contracts). This may make it easier for people to find at least some work, even though they may be under-employed (ILO, 2015). l Relatively meagre social support for the unemployed (OECD. Stat, 2022). This may encourage people to stay in, or start, a job even if it is unsuitable, precarious or inadequately paid. You will look further at the economic theory of the labour market in Chapter 7. 21 Chapter 1 Crises: causes and effects 3 Why do crises happen? Post-Keynesian There are different ways of viewing the economy and the crises that it Refers to economists periodically experiences. One perspective, which is grounded in who interpret the neoclassical economics, sees crises as external shocks to the economic theories of the UK system. Another approach, which is associated with the Post- economist John Maynard Keynes Keynesian school of economic thought, proposes that crises are a (1883‒1946) in order product of the economic system itself. to build an alternative understanding of how This section briefly looks at what each approach implies about the the macroeconomy fragility of the economic system in terms of its exposure to crises. works from that offered by neoclassical economics. 3.1 External shocks In neoclassical economics, crises are treated as bolts out of the blue Neoclassical economics assumes that what happens in the macro- economy is the sum of individual actions: 22  3 Why do crises happen? Utility A numerical l Households are assumed to choose goods and services in order to representation of the maximise their satisfaction – called utility in economics amount of satisfaction terminology. derived from consumption. l Firms are assumed to make choices about what they produce in order to maximise their profits. l Markets bring these agents together (you will explore this in Book 2). Households and firms are assumed to make rational choices based on all relevant information and the result is that, as they interact, markets produce the best outcomes for both. Since the macroeconomy is the interlinked system of all these markets, it is assumed that when all the individual markets are functioning well, the economy as a whole also operates in the best possible way for everybody. In this view of the economy, normal fluctuations in economic activity are just temporary adjustments. These may be caused by the time taken for factors of production to shift from one use to another; for example, workers gradually shifting from the oil industry to wind-farm manufacture. Alternatively, problems might occur because of misguided policy interventions or barriers to the efficient working of markets, such as trade unions pushing for higher wages. This view of the world implies that policy should be hands off (called laissez-faire), leaving markets free to adjust to the ‘correct’ level. The Laissez-faire system regulates itself and the main role of policy is to ensure that Doctrine proposing markets operate as efficiently as possible. that the best social outcomes are achieved In this self-regulating system, crises must be due to external (in other by allowing markets to words, exogenous) shocks. An example would be an abrupt increase operate with minimal in global energy prices – which, as you saw in Figure 1.1, has been a government intervention. common factor in several crises, notably during the 1970s and with the combination of the aftermath of the COVID-19 pandemic and the Exogenous Ukrainian war during 2021–2022. Strictly applied, the neoclassical view Originating from would be that, even in the event of such crises, the economy should be outside the system or left alone to recover by itself. model. 23 Chapter 1 Crises: causes and effects 3.2 The Keynesian Revolution The hands-off neoclassical approach to managing the economy was sorely tested and found wanting during the Great Depression of the 1930s. That crisis, which you will learn about in Chapter 3, was characterised by large-scale unemployment in the UK, the United States (US) and continental Europe. Far from recovering by itself, the crisis persisted year after year. The dominant neoclassical theory of the time blamed persistent unemployment on trade union activity and misguided government policies that were preventing wages from falling sufficiently and so preventing the economy from returning to a healthy state. However, this view was challenged by the influential UK economist John Maynard Keynes (1883–1946), who argued that there was no natural tendency for economies to return to health. On the contrary, economies could get stuck in a state of high or increasing unemployment. Thinking about the circular flow of income that you looked at in Section 2.2 (Figure 1.2), falling wages meant falling consumption. This meant firms couldn’t sell all their goods or earn enough profit, making them more inclined to cut rather than expand production and employment. Keynes’s solution was for the government to intervene by injecting its own new spending into the circular flow of income in order to jump-start the economy onto an upward spiral of increasing output, employment, income and consumption. This heralded the start of what became known as the ‘Keynesian Revolution’ which stamped its mark on economic policy from the 1940s through to the 1970s across various countries. However, the Keynesian focus on policy intervention to support employment and growth fell out of favour in the 1970s with the emergence of Stagflation stagflation and a shift of policies in the US and UK back to the A combination of neoclassical tradition. The charge was that Keynesian policies had built stagnant economic into the economy a tendency towards inflation and that policy growth and high interventions should instead focus on controlling that. inflation. 24  3 Why do crises happen? 3.3 Fragility within the economy The 2008 Global Financial Crisis revived interest in the ideas of Keynes Interest in Keynesian-inspired policies revived with the 2008 Global Financial Crisis, when the bankruptcy of the investment bank, Lehman Brothers, exposed how close all major banks were to collapse and financial markets froze. Building on Keynes’s (1936) analysis of how economies function, the Keynesian revival offered solutions for tackling the crisis and for explaining why it had happened. The idea of crises being due to external shocks did not sit well and led to an examination of the economic system itself as a source of instability, particularly because of the importance of time and the financial sector. Financial sector The organisations and First, thinking about time, the neoclassical idea of all markets in the markets that provide economy tending towards a simultaneous harmony glosses over the financial services to reality of how consumption and investment decisions are made. Many households and firms, decisions involve spending, borrowing or saving now in order to reap such as banks, bond future benefits; for example, when a firm borrows funds to invest in and stock markets, insurance companies new technology with the aim of generating future profits. However, and investment firms. these are not the carefully calculated rational decisions that neoclassical economics assumes – they cannot be, because the future is riven with 25 Chapter 1 Crises: causes and effects Uncertainty uncertainty, not simply risk. It is important not to confuse these two Where the chance of concepts. something happening cannot be measured or US economist Frank Knight (1885–1972) is credited with first drawing estimated. a distinction between risk and uncertainty (Knight, 1921). For Knight, Risk economic agents make decisions in the context of constant change. In Where the chance of itself, change is not a barrier to rational decision-making as long as the something happening likelihood of possible changes – in other words, the risk – can be can be measured or measured or estimated; for example, by calculating a statistical estimated. probability based on patterns that have been observed in past data. The problem lies with uncertainty – those future changes which do not follow previous patterns and so cannot be assigned a probability, or which are so entirely different from anything seen before that they were not even imagined at the time a decision was made. Uncertainty leaves decision makers following their instincts rather than a set of careful, probability-weighted calculations. Now, let’s turn to the financial sector. Post-Keynesian theorists such as US economist Hyman Minsky (1919–1996) recognise that finance has a special role in the economy. Finance is the link that enables economic decisions to play out over time, and the financial sector is key in determining how much financial risk and uncertainty gets embedded into the economy. For example, imagine a firm wants to make a large-scale investment to generate future profits. It has various options for financing the investment (which you’ll look at in more detail in Chapter 5), but a common option is to turn to the financial sector to borrow the required money. Minsky (1978) identified three types of finance: l Hedge finance: this is where the future income from the project is expected to be enough to meet the agreed debt repayments in every time period. Given that the future is both risky and uncertain, a prudent agent will be cautious in its projections of future income and may well have some savings or other assets that could be used to meet the repayments if the project’s income falls short of the amounts required. l Speculative finance: this is where the future income from the project is expected eventually to be enough to meet the total debt repayments but will not be enough in the immediate future. However, expected income is enough for now to cover the interest on the debt. l Ponzi finance: this is where the expected income in the immediate future is not even enough to cover the interest on the debt. 26  3 Why do crises happen? Typically, these schemes involve buying assets on the assumption that their value will rise, enabling the debt to be repaid in the end plus a handsome profit. With both speculative and Ponzi finance, the borrower can manage the debt only by periodically borrowing more to meet the repayments or by selling off assets to raise the required money. Box 1.3 ‘Ponzi’ explained Charles Ponzi, an Italian migrant to the US, made an estimated $15 million in 1920 by offering investors eye- watering returns that seemed to materialise, but were in fact paid out of the money deposited by subsequent new investors (Darby, 1998). The scam collapsed when the supply of new investors ran dry. Ponzi was not the first, and certainly not the last, to operate this type of fraud, but it has become known ever since as a ‘Ponzi scheme’. Charles Ponzi (circa 1920) whose name became synonymous with a scam While Ponzi scams are designed to deceive and are usually illegal, Ponzi finance is not necessarily illegal or deceptive. However, Ponzi finance relies on a similar device to the scam. In order for an asset’s price to rise – essential for generating the anticipated return – other investors must deposit funds. Once the investors dry up, the asset price collapses. 27 Chapter 1 Crises: causes and effects Minsky (1978) argues that the stability of an economy depends on the mix of these three types of finance (hedge, speculative and Ponzi). To see why, consider the business cycle which you were introduced to in Section 2. Minsky (1978; 1992) developed a ‘financial instability hypothesis’ to explain the business cycle and how it could tip the economy into crisis. Figure 1.5 illustrates the three stages: l Stability: during a period of stable economic growth, most investment is funded with hedge finance. The projects generally do well because they have been prudently financed with modest profit expectations. l Increasing instability: as stability persists, investors – both firms and those buying financial assets – and banks who lend to them become more confident, seeing the chance for more projects and bigger profits. Increasingly, projects are funded with speculative finance and, as the boom really takes off, Ponzi finance grows too. l Crisis: at some point, the enthusiasm evaporates; for example, because the cost of borrowing rises or doubt grows that profits really will materialise. As a result, asset prices start to collapse, meaning that the loans represented by Ponzi finance become worthless. This triggers further falls in asset prices, more failing loans and an increasing unwillingness of the financial sector to roll over existing loans or make new ones. Lending dries up – a situation called a ‘credit crunch’ – and economic activity abruptly enters a downward spiral. As profits slump, the interest on some previously speculative finance can no longer be paid, turning it into Ponzi finance. Even some hedge finance becomes speculative, adding to the worsening situation. The economy is in crisis. If the assets are widely held across different countries, the crisis can even be global. 28  3 Why do crises happen? Ponzi Peak Credit finance crunch Bust Speculative GDP growth finance Boom Hedge finance Stability Increasing instability Crisis Time Figure 1.5 A Minsky business cycle A key point to note about the financial instability hypothesis is that the original stability of the economy is the very cause of the ultimate crisis. It is stability that leads to growing confidence and the rising use of unstable forms of financing. In other words, economic crises can be endogenous with their origins lying within the system itself. The Endogenous greater the proportion of speculative and Ponzi finance, the more Originating within the fragile the economic system becomes and the more vulnerable it is to a system or model. crisis developing. An implication of Minsky’s theory is that, when crisis occurs, the role of policy intervention should be to replace the finance which the financial sector has suddenly withdrawn. A dramatic example of this was the response of governments to the 2008 Global Financial Crisis (see Box 1.4). 29 Chapter 1 Crises: causes and effects Box 1.4 The 2008 Global Financial Crisis The origins of the Global Financial Crisis can be traced back to accelerating growth and innovation in the financial sector from the mid-1980s. This followed ‘financial deregulation’ in the US, UK and parts of Europe, meaning the removal of previous restrictions on the free operation of their financial markets. One of the innovations was the development of ‘mortgage- backed securities’. Previously, the banks and other institutions that lent to households for home purchase would hold those mortgages themselves as assets of their business. But the practice quickly developed of turning the mortgages into Securities securities that could be sold to investors. The original lender Financial investments, would receive a lump sum on the sale of a bundle of such as shares or mortgages. The investors who bought the securities backed by bonds, that can usually the mortgages would receive an income over the years from be traded on stock households’ mortgage repayments or could instead sell the exchanges or other securities to other investors. markets and which are issued by firms and This ‘originate-to-sell’ practice (creating mortgages and then governments as a way selling them on as securities) was popular and profitable for of raising money. lenders. As US house prices boomed during the 1990s and early 2000s, business expanded beyond just financially secure homeowners (‘prime borrowers’) to making loans to ‘subprime borrowers’ (borrowers who would not normally have been able to afford a mortgage). To make these latter mortgages manageable, they were typically offered at a low initial interest rate. Later, the rate would rise, but since house prices were booming, the borrower would then be able to take out an additional loan to meet the increased repayments. Meanwhile, further innovation in the financial markets included Derivatives new types of derivatives whose value depended on the Securities whose value market price of the mortgage-backed securities. Financial firms is derived from some such as the big banks invested heavily in both mortgage- underlying asset (such backed securities and these derivatives, often themselves as shares, mortgage- borrowing to increase their stake in these lucrative backed securities or investments. currencies) or benchmark (such as interest rates). 30  3 Why do crises happen? Then in 2007, the unthinkable happened: US house prices started to fall and carried on falling for the next two years. When subprime borrowers’ mortgage rates increased, borrowers could no longer get further advances because the value of their homes had fallen and even selling the homes could not raise enough to pay off the mortgages. The securities backed by these mortgages became worthless, along with the derivatives linked to them. Banks found that, instead of holding lucrative investments, the value of these assets had evaporated, leaving these banks on the brink of insolvency. Fear and uncertainty escalated. Financial firms became wary of lending to each other, even for the routine functions that support normal economic activity, causing a credit crunch that threatened to stall the whole economy. Governments were forced to step in with huge injections of public money, funded by government borrowing, to stop the banking system, and consequently the economy, collapsing. While data does not exist to measure firms’ borrowing categorised into Minsky’s three types of finance, it is possible to track changes in the overall level of borrowing by firms and governments in the run-up to, and aftermath of, the Global Financial Crisis. The stacked charts in Figure 1.6 show debt outstanding for governments, firms (non-financial) and US households between 1999 and 2021, along with GDP growth for high-income countries and the period of recession (the shaded area). Be aware that the bottom chart in Figure 1.6 shows levels of debt outstanding as a percentage of GDP. It is likely that borrowing, for example by firms to finance investment, will tend even in normal times to go up and down in line with the level of economic activity. Showing the level of debt outstanding as a percentage of GDP enables you to see whether changes are disproportionately large or small relative to economic activity. 31 Chapter 1 Crises: causes and effects High-income countries’ GDP growth (% a year) 4 2 0 -2 -4 -6 Debt outstanding as % GDP 140 120 100 80 60 01 06 16 21 11 20 20 20 20 20 Advanced economies - government Advanced economies - non-financial firms US households Figure 1.6 High-income countries’ GDP growth, debt outstanding and US household debt outstanding, 1999–2021 (data from Bank for International Settlements, 2021; World Bank, 2022) Note: GDP is in ‘real terms’. 32  3 Why do crises happen? Activity 1.4 The Global Financial Crisis: a ‘Minsky moment’? Allow 25 minutes for this activity The 2008 Global Financial Crisis has been called a ‘Minsky moment’ (Davidson, 2010), characterising it as the topple from the peak of a Minsky business cycle. Using the account of the crisis in Box 1.4, including Figure 1.6, answer these questions: 1 Following the example of a Minsky business cycle in Figure 1.5, roughly mark the three stages of stability, increasing instability and crisis in Figure 1.6. 2 Does the account of the crisis in Box 1.4 suggest that, in the build up, there was any use of Ponzi finance? 3 Once the crisis hit, is there any evidence that banks stopped lending to non-financial firms? 4 Looking at Figure 1.6, what might explain the return of GDP to positive growth from 2010 even though lending to non-financial firms still seemed to be depressed? The answers to this activity are at the end of the chapter. 33 Chapter 1 Crises: causes and effects 4 Inflation and deflation as crises In this chapter, we have mentioned inflation several times; inflation means a sustained rise in the general price level in an economy (as distinct from a temporary increase or fluctuations in a few prices relative to others). A low and stable increase in prices each year is not a problem. In fact, most governments use policy interventions to actively target a small, positive inflation rate, often around 2–4% a year (Central Bank News, 2022). Inflation may turn into a crisis if it becomes high and/or unstable. It is especially problematic when inflation occurs during a Deflation recession (see Box 1.5). Deflation – where prices are falling rather A general decline over than rising – is also a problem, as you will see in Section 4.3, and was time in the price level a feature of the 1930s Great Depression which you will study in of a country. Chapter 3. Before considering why inflation or deflation crises matter, let’s first look at how inflation is measured. Box 1.5 Energy crises In 1973–1974, the main oil-producing countries (members of OAPEC) oversaw an abrupt four-fold increase in the price of oil (Office of the Historian, no date). Oil was not only consumed directly (for example, as petrol) but was also the main energy input into the production and transportation of most other goods and services. Therefore, the price rise suddenly increased most firms’ production costs, leading to both a recession in oil-importing countries around the world and a period of high price inflation. The term ‘stagflation’ was coined for this deadly combination of stagnant output and soaring inflation. 34  4 Inflation and deflation as crises Natural gas production in Russia A similar situation developed in 2022 as economies around the world were simultaneously emerging from the COVID-19 crisis, all wanting to resume consumption and production at the same time, which put upward pressure on global natural gas prices in particular. Gas and oil prices escalated further with the Russian invasion of Ukraine on 24 February 2022, which disrupted exports of natural gas from Russia, a major supplier. Costs for energy-intensive industries – including fertiliser production – soared, contributing to price inflation in other sectors such as food. As you will see in Part 3, stagflation poses an especially tough challenge for policy intervention. 4.1 Measuring inflation Inflation is a measure of how prices change over time. One common approach is to take a basket of goods and services that a typical consumer would buy and conduct regular (usually monthly) surveys of the price of every item in the basket. The prices are weighted and combined, with the weights reflecting typical spending on each item based on surveys of household expenditure. Let’s look at a simple example with just three items in the basket: bread, apples and electricity. Imagine an expenditure survey finds that a 35 Chapter 1 Crises: causes and effects typical household spends 50% of their income on bread, 30% on apples and 20% on electricity. A general price level could be calculated as: Assume the prices of each item in January and February 2022 are as shown in Figure 1.7. January £1.00 80p 25p February £1.05 75p 40p Figure 1.7 Change in the prices of three items Using Figure 1.7, the general price level for January would be 0.79: In contrast, the general price level for February would be 0.83: Consumer price Figures like ‘0.79’ and ‘0.83’ are a bit arbitrary. So, general price levels index (CPI) like these are usually converted into an ‘index’, commonly called a A weighted average of consumer price index (CPI). To create an index, one particular time the prices of a basket period is chosen as the ‘base period’. An index has two important of consumer goods and services that typically characteristics: accounts for l the index value of the base period is always 100 consumption expenditures of the l the index value for any subsequent period is 100 plus the average consumer. percentage change since the base period. Let’s see how this index works by building on the example of having bread, apples and electricity in the basket. Any time period can be chosen to be the base period – let’s choose January 2022. So, instead 36  4 Inflation and deflation as crises of saying that the price level in January 2022 is 0.79, it now has a value of 100. Next, the value for February 2022 (0.83) needs to be converted into an index number. First, the percentage change in the price level from January 2022 to February 2022 is calculated. Using the standard method for working out percentage changes, the calculation would be: So the percentage change in the price level from January 2022 to February 2022 is 5.1%. The index value for February is the base value plus the percentage change relative to the base value: The index value for each subsequent month and earlier months can be calculated in the same way. For example, Table 1.1 shows the CPI for a period of 14 months for the fictional example of bread, apples and electricity. Each index number expresses the percentage change in prices relative to the base period (January 2022 = 100). For example, in August 2022, the index value is 110.6. This means that the price level is 10.6% higher than in January 2022. Table 1.1 Consumer price index – a fictional example of bread, apples and electricity Year Month Index Base: January 2022 = 100 2021 November 99.0 December 99.2 2022 January 100.0 February 105.1 March 106.7 April 108.3 May 108.3 June 108.9 July 110.1 37 Chapter 1 Crises: causes and effects Year Month Index Base: January 2022 = 100 2022 August 110.6 September 111.2 October 111.7 November 112.2 December 112.8 Instead of calculating percentages in order to construct the index, the Inflation rate process can be reversed to calculate the inflation rate, which is the The rate of change of percentage change in the index over a specified period. The percentage the price level in an change that most interests economists and policymakers is usually the economy. annual inflation rate, meaning the change in prices over the most recent 12 months. Using the data from Table 1.1 and the standard method for working out percentages, the annual inflation rate for November 2022 could be calculated as follows: The equation for calculating an inflation rate from a CPI can be generalised as: Activity 1.5 Calculating the annual inflation rate Allow 10 minutes for this activity Using the equation above and the data in Table 1.1, calculate the annual inflation rate for December 2022. Round your answer to one decimal place. The answer to this activity is at the end of the chapter. 38  4 Inflation and deflation as crises 4.2 Why inflation matters The impact of economic crises on households are different, depending on whether they result in unemployment, inflation or both. The impact of unemployment is abrupt and brutal: one day you are busy with your job; the next day you are out of work and your main source of income is gone. Inflation also affects income, but often in a gradual, barely visible way: the amount that a nominal sum of money can buy is Nominal reduced bit by bit. In other words, the purchasing power of the Nominal values are income falls, which means living standards are gradually eroded. expressed in terms of prices at the time of measurement. Activity 1.6 UK inflation over time Purchasing power Allow 10 minutes for this activity The ability to afford a certain number of Figure 1.8 shows the annual inflation rate for the UK over a long-term goods and services span, 1800–2022. Study the chart and describe the patterns you see. with a given amount of money. 40 Annual inflation rate, % 30 20 10 0 -10 -20 -30 1800 1837 1874 1911 1948 1985 2022 Figure 1.8 UK annual inflation rate, 1800–2022 (data from Office for National Statistics, 2022c; Bank of England, 2022) Answer Perhaps the most surprising observations from Figure 1.8 are that deflation, which we think of as being unusual, was historically common; and until about 1860, inflation and deflation succeeded each other in quick succession and the swings were large, possibly due to the impact on trade of frequent wars and following cycles of good and poor harvests in what was still a heavily agrarian economy.(Hills et al., 2010). 39 Chapter 1 Crises: causes and effects By the 1910s, inflation had become low and relatively stable. However, you can see a clear association between inflation and war with spikes in inflation in 1914–1918, 1939–1945 and 2022. The phenomenon of continuous inflation is relatively modern, dating from the late 1930s, perhaps lending weight to the idea that Keynesian policies promoted inflation (see Section 3.2). You can clearly see the 24% spike in inflation in 1975 after the OAPEC oil price crisis and another 18% peak in 1980, again partially linked to oil prices. From the mid-1990s until 2022, inflation was mostly positive but at a low and stable level. Price inflation need not erode living standards if incomes increase by at least the same rate. In Figure 1.9, you can see that in the UK, in most years wage inflation has exceeded price inflation (the dashed line lies Real wage above the solid line), meaning that the real wage has tended to rise. The remuneration for Real is the term used to describe any value that has been adjusted to labour adjusted for the take account of the effect of changing prices, so the real wage is a cost of living in the measure of the quantity of goods and services that can be bought with economy. the nominal wage. Real The nominal value adjusted for inflation by expressing it in terms of prices in a 30 specified base year. Annual rate, % 20 10 0 -5 1949 1961 1973 1985 1997 2009 2021 Wage inflation Price inflation Figure 1.9 Wage inflation and price inflation in the UK, 1949–2021 (data from Office for National Statistics, 2022b; Office for National Statistics, 2022c) 40  4 Inflation and deflation as crises However, it’s important to bear in mind that macroeconomic data, such as the real wage, does not capture the experience of different individuals within the economy who may be affected in very different ways. First, only some parts of society derive their income from wages; others rely on profits from self-employment, welfare payments and pensions. While trade unions and individual employees may bargain for nominal wage rises that keep pace with price inflation, pensioners, benefit recipients and non-unionised labour usually do not have similar power to protect the real value of their income. Second, when considering the impact of price inflation, bear in mind that it does not simply affect incomes. It affects the purchasing power of all nominal monetary values. Therefore, general price inflation also affects assets and debts. This is a disadvantage for those who hold wealth as they see the real value of their savings fall, but conversely it is an advantage for those who have loans outstanding since the real value of those debts falls. (However, sometimes rather than general prices rising, an economy may experience periods of asset price inflation, such as rising house prices. Asset price inflation benefits those who hold the assets.) Summing up then, inflation is important because it can affect standards of living and the distribution of income and wealth. You will look in detail at inequalities in income and wealth distribution in Chapter 17 in Book 2. Inflation is also important to the overall level of economic activity. Research suggests that high levels of inflation – above, say 17% a year – are associated with lower GDP growth and employment (Kremer et al., 2013). 4.3 Why deflation matters Deflation can be just as problematic as inflation. On the face of it, deflation might seem beneficial because it increases the purchasing power of a nominal sum of money, potentially raising living standards. However, it is important to factor in the behavioural response of economic agents to deflation. Imagine that you are planning to buy a major household item, such as a sofa or home cinema system. If you expect the price of this item to fall in future, are you more inclined to buy it today or to wait until 41 Chapter 1 Crises: causes and effects next year when it may be cheaper? Now, imagine that many prices across the economy are falling: you might be inclined to delay as much spending as possible. Think back to the circular flow of income in Figure 1.2. If consumption falls, firms cannot sell all they produce. They may cut production and lay off workers, meaning that household incomes fall. This in turn may prompt consumers to spend even less, and so a downward spiral develops and may tip the economy into recession. Deflation also affects assets and liabilities. It benefits those who have wealth because the real value of savings increases. By the same token, the real value of liabilities also rises, which is detrimental to those who have debts. 42  5 Climate change as an economic crisis 5 Climate change as an economic crisis The ‘modern’ economy, with most people working for firms, began