ECN1014 Introductory Economics

Tutorial 8: Measuring National Output and Income

Extract 1: An international comparison of competitiveness

The table shows the ranking of Switzerland, Singapore and the UK in selected ‘pillars of
competitiveness’ in 2016-2017.

pillars of competitiveness Switzerland Singapore UK

infrastructure 6 2 9
health and primary education 8 2 17
financial market development 8 2 16
business sophistication 1 19 7
innovation 1 9 13

Source: The Global Competitiveness Report, 2016-2017.

In the same year, the World Bank reported that the UK’s total GDP (measured in millions of US
dollar) was ranked 5th largest in the world, followed by Switzerland (20th) and Singapore (36th).

Extract 2: Brexit and UK’s standard of living

Britain’s households may not be entirely unaffected by Brexit and the economic and political
controversy around the referendum. Inflation forecasts have risen rapidly since the referendum,
as import prices will rise in the months and years ahead. If incomes rise faster than prices, inflation
is less of a burden. However, prices are set to rise by 2.4% in 2017 according to independent
forecasts compiled by the Treasury, exactly the same pace as earnings, meaning Britons will
experience no real pay growth.

This is a distinctly gloomy outlook and one which will worsen the UK’s overall economic prospects.
Consumer spending is the big driver of the economy and flat earnings mean less potential for
economic growth. The situation becomes something of a vicious circle where poor spending
results in less growth, resulting in less room for pay rises and less spending. Although the
economy will probably keep growing in 2017, it is predicted that the risk of surging inflation and
weak consumer growth could still tip the UK into a contraction. A looming spike in inflation and a
slowing jobs market will soon eat into real wage growth, limiting households’ ability to increase
consumption without taking on more debt.

Since 2010 the government has been slashing the number of workers on its payroll, cutting public
employment from a high of 6.37 million in late 2009 to 5.33 million today. Clearly there is little
pressure to push up wages – the government is not trying to recruit more people. It has also
clamped down on pay rises to reduce budget deficit.
Some economists believe a fall in immigration could cut the supply of workers. Migration has kept
Britain’s demographics relatively young compared to Europe. However, with post-Brexit migration
controls, it would be difficult to keep the UK’s GDP at its previous trend rate of growth.

As a long-term source of growth in GDP, wages and living standards, finding a way to boost
productivity is something of a holy grail. Manufacturing industry body EEF wants the government
to invest more in the UK’s digital infrastructure to make it easier for companies in low-productivity
areas to do business via high-speed internet. The Chartered Institute for Personnel and
Development, the North East Chamber of Commerce and the Confederation of British Industry
are all urging the Government to avoid a skills shortage by ensuring that foreign workers can still
move to the UK. Foreign students and academics are key to improving skills and building a
network of UK contacts globally, they suggest, boosting trade and investment in the long term.
Extra vocational training would help to increase productivity and wages, particularly among the
lower paid, the groups argue, while better transport links would help workers get to the best jobs
where they can be most effective.

Source: The Telegraph, 29 October 2016.

(a) Examine the macroeconomic issues of economic growth, unemployment and inflation
raised in the above extracts.

(b) (i) What is meant by ‘injections’ and ‘withdrawals’ in the circular flow of income?

(ii) With reference to Extract 2, explain how a reduction in budget deficit might affect
the state of equilibrium in the circular flow of income

(c) (i) Define the term ‘Gross Domestic Product’ (GDP).

(ii) To what extent is GDP an accurate measure of the standard of living?

ECN1014 Introductory Economics
Tutorial 9: The Aggregate Demand-Supply Model
and Macroeconomic Problems
UK economy in 2018: steady growth tempered by Brexit politics

There are some reasons to be cheerful about the prospects for the UK economy. Despite the
political uncertainty of the past year, the UK economy enters 2018 in better health than many
would have given it credit for. The post-referendum recession never materialised. Consumers
have kept calm and carried on spending against the odds, and global growth and a resurgent
Eurozone are helping to sustain British manufacturers. Apart from the recovery in the global
economy, British manufacturers stand to benefit from selling their goods abroad, helped by the
pound’s weakness since the Brexit vote making British goods more competitive.

However, households are still facing higher inflation and sluggish wage growth, which could hold
back economic growth. British households saw prices in the shops rising at rapid rates. This is
because of the weak pound, which has pushed up the cost of importing goods to the UK. Wages
have risen nowhere near as much. The impact from sterling’s rapid devaluation on inflation,
nevertheless, is fading out gradually. The Bank of England reckons the rate of inflation, as
measured by the consumer price index (CPI) probably peaked just above 3% in the final months
of 2017 and is on track to fall in the coming months.

Britain is set to have the worst wage growth of any wealthy nation in 2018, however, as real
earnings lag behind inflation. Wages are expected to remain flat over the course of the year once
inflation is taken into account. With wage growth stalling and prices rising, many households are
having to rely on credit cards and loans to get through the month. People raiding their savings
and borrowing more than they can afford is what helped drive the last financial crash. Stagnant
real wages have been a significant drag on the overall economic recovery in recent years by
holding back consumers’ purchasing power.

There are worrying signs that Britain’s long jobs boom appears to be over. Official data for job
creation is now showing a drop. The number of people in work across Britain fell by 56,000 to just
over 32 million during the three months to October. The Office for Budget Responsibility (OBR)
expects the rate of unemployment to rise over the next five years. Strong levels of employment
growth in the earlier months of 2017 have been positive for the public finances, with the Treasury
raking in more money from taxes than forecast by the OBR. With the rate of unemployment
expected to rise, the government’s finances may once again be dented.

Political uncertainty will also force businesses to delay much-needed investments to boost
productivity. Captains of industry say the end of March is the deadline for a deal on the terms of
transition to exit the EU. If that deadline is missed, they would be forced to make decisions that
could have negative consequences for jobs and investment. Businesses could put their
investment plans on ice if concerns about the UK’s future trading rules with the EU linger.

Given the uncertainties facing the UK economy as Brexit talks intensify, the Bank of England
looks set to leave interest rate relatively steady in 2018 – which will help the most hard-pressed
households with cheap borrowing costs. At most, interest rates may be nudged higher from 0.50%
to 0.75%. Should there be a move higher, it will only be limited and gradual, and it should be
manageable for most. Just a third of households have a mortgage on their home and the majority
have a fixed rate deal, meaning they will not see any immediate change until the term of their
mortgage comes to an end. Those feeling the change will only see an increase in debt servicing
costs of about £15 a month from a 25 basis point increase in rates, according to a Bank study.

Source: The Guardian, 31 December 2017.

(a) (i) Define the term ‘aggregate demand’.

(ii) With reference to the slope of an aggregate demand curve, explain how ‘stagnant
real wages’ in connection with rising prices are ‘holding back consumers’ purchasing
power’ (paragraph 3).

(b) Analyse what determines the level of investment expenditures and net exports in the UK
economy.

(c) Using an aggregate demand-supply diagram, explain how the weak pound, by pushing up
the cost of imported materials, might leave policymakers without any trade-off between
inflation and unemployment.
ECN1014 Introductory Economics
Tutorial 10: Money, Inflation and the Financial System

Article 1: UK households’ savings fall to record low in warning sign for economy

British households ran down their savings to a record low at the end of 2016, raising fears that
the UK is on course for a fresh consumer debt crisis in the wake of the Brexit vote. The saving
ratio – which estimates the amount of money households have available to save as a percentage
of their total disposable income – fell sharply in the fourth quarter of 2016 to 3.3% from 5.3% in
the third.

It was the lowest since records began in 1963, according to the Office for National Statistics
(ONS), and suggested that people are increasingly dipping into their savings to maintain spending
at a time when prices are rising. A fall in disposable incomes also raised concerns that people will
increasingly rely on debt-fuelled spending as a squeeze in living standards takes hold. With wage
growth stalling and prices rising, many households are having to rely on credit cards and loans to
get through the month. The Bank of England said rapid growth in consumer credit, underpinned
by an acceleration in credit card borrowing, was one of the main threats to the UK banking system.

Source: The Guardian, 31 March 2017.

Article 2: Bank of England warns a consumer debt crisis could cost banks £30 billion

The Bank of England has issued its strongest warning yet about the UK’s ballooning consumer
debt, saying Britain’s banks could incur £30 billion of losses on their lending on credit cards,
personal loans and for car finance if interest rates and unemployment rose sharply. After
assessing the fast growth in the consumer credit market, the central bank is requiring the banking
system to hold an extra £10 billion of capital as protection against any future losses after finding
that lenders are underestimating their exposure to bad debts in an economic downturn.

While the Bank of England is not concerned that consumer debt will be a risk to economic growth
as it is only 11% of household debt, it is a risk to lenders’ ability to withstand losses in a downturn
as these loans are less likely to be repaid when consumers lose their jobs or face higher interest
rates. Credit cards would be most severely affected with a 25% default rate, with 15% for personal
loans and 10% on car finance. At present, the banks are placing too much weight on the recent
performance of consumer lending in benign conditions as an indicator of underlying credit quality.
As a result, they have been underestimating possible losses in a downturn.

Shares in banks were knocked and profits could be hit by the Bank of England’s sounding the
alarm on rising debt levels. Any restriction on lending, particularly unsecured lending like credit
cards and car loans would be a direct hit to a big profit centre for banks and insurers. Requiring
banks to hold more capital against consumer credit could lead to them pushing up interest rates
or being more selective about their lending to cover their additional costs.
The charitable group, StepChange, said more needed to be done to help ‘millions of households
trapped in spiralling persistent debt’. Action is needed to stop products like credit cards and
overdrafts walking people into difficulty, and lenders must do more to help people safely manage
their way out of persistent debt. Rising prices and sluggish wage growth are squeezing incomes
and prompting some households to run down savings or turn to loans to cover their living costs.

Source: The Guardian, 25 September 2017.

(a) Explain the following terms:

(i) broad money,

(ii) statutory liquidity ratio

and (iii) fractional-reserve banking.

(b) Using appropriate numerical demonstration, describe how a commercial bank creates
money through lending.

(c) (i) How do commercial banks maintain liquidity and profitability, respectively?

(ii) Drawing upon information in Article 2, explain in what ways rising household debt
illustrates the inherent conflict between profitability and liquidity faced by
commercial banks.

(d) ‘Rapid growth in consumer credit, underpinned by an acceleration in credit card

borrowing, was one of the main threats to the UK banking system’ (Article 1).

With reference to the above statement, explain why fractional reserve banking tends to
create macroeconomic instability.
ECN1014 Introductory Economics
Tutorial 11: Monetary Policy

Bank of England’s talk of rate rise while winding down QE beggars belief

Michael Saunders surprised many when he voted in June 2017 for the Bank of England to
increase interest rates. The former Citigroup economist, who joined the Bank’s nine-strong
monetary policy committee (MPC) last year as one of the four external members, warned that the
UK economy was performing well enough for inflation to become a challenge. The response, he
said, should be a modest rise in the cost of borrowing for businesses and households.

However, official figures showed inflation falling back. Over the summer the annual rise in
consumer price inflation (CPI) declined from a peak of 2.9% to 2.6%. Worse was to come.
Consumer and business confidence data showed both groups were becoming more nervous
about the future. Businesses are preparing for a slowdown in profit growth and domestic sales.
Financial firms also see the largest drop in sentiment. A survey by the manufacturers’ organisation
(EEF) showed that since the EU referendum there has been a sharp rise in the proportion of
executives planning to put off their investment in plant and machinery over the next two years in
response to growing worries about the prospects for demand as well as the spike in political
uncertainty. Figures from the Office for National Statistics also showed GDP growth failed to
rebound from its miserable performance in the first quarter. It was stuck in the slow lane, only
inching higher from 0.2% in the first quarter of 2017 to 0.3% in the second. Surely the gloomy
data was a humiliating blow to Mr. Saunders’ forecasting ability. He reckoned inflation was
heading upwards to 3% and possibly beyond. The hard facts pointed in the opposite direction.

Undaunted, Mr. Saunders maintained his warning, claiming that the fall in inflation was temporary
and it was still in danger of becoming entrenched. His explanation centred on three things that
would force employers to raise pay rates. First, that unemployment would stay low despite Brexit
jitters. Second, that a flight of EU nationals back across the channel would restrict the supply of
labour, putting upward pressure on wages. Third, he pointed to studies that showed most workers
are unwilling to take on more hours. It is true that some industries are already screaming for skilled
staff. The construction industry is under pressure to find people to fill the holes left by departing
Polish and Lithuanian workers.

At the moment the only harm to the economy flows from the EU referendum. In the first instance
there was the uncertainty that killed off business investment. A year after the vote, businesses
remain reluctant to buy new equipment or expand capacity. Subsequently, the weakness of pound
sterling pushed up the cost of imported goods, hitting disposable incomes.

The Bank of England embarked on quantitative easing (QE) in the wake of the 2008 financial
crisis in an attempt to stimulate economic growth. It is incredible why the central bank would wind
down QE when the government still maintains its fiscal tightening and businesses consider the
unknowns thrown up by the Brexit talks. Fear and uncertainty themselves, indeed, can have a
powerful impact on economies and blunt the effect of monetary action. Firms might become
incredibly cautious when uncertainty goes up: they do not react to either good or bad news.
Understandably too, in times of uncertainty banks may have little enthusiasm for making risky
new loans. Without the government pushing ahead with extra spending on infrastructure and
higher pay for nurses and teachers as a way to stimulate the economy, winding down QE makes
little sense. While the UK resembles a hospital patient on heavy medication, withdrawing the only
macroeconomic stimulant would surely be negligent.

Source: The Guardian, 31 August 2017.

(a) An economist warns that ‘the UK economy was performing well enough for inflation to
become a challenge’ (paragraph 1).

Explain the three monetary instruments by which rising inflationary pressure can be
contained.

(b) ‘The Bank of England embarked on quantitative easing (QE) In the wake of the 2008
financial crisis in an attempt to stimulate economic growth’ (paragraph 5).

(i) Relative to open market operations, how is ‘quantitative easing’ supposed to work
during a recession?

(ii) Describe, using diagrams, the impact of ‘quantitative easing’ on the level of national
income.

(iii) On what conditions does the effectiveness of ‘quantitative easing’ depend?

ECN1014 Introductory Economics
Tutorial 12: Fiscal Policy
Article 1: How could Philip Hammond ‘reset’ the UK's economic policy?

Britain’s Chancellor of the Exchequer, Philip Hammond, has declared that he is ready to ‘reset’
the government’s fiscal policy to respond to any slowdown caused by the UK’s decision to leave
the European Union. After six years of austerity, analysts believe that this is a further signal that
the Treasury will loosen the purse strings within months. The Chancellor has already outlined his
willingness to borrow ‘when the cost of money is cheap’, an indication that the government could
accept an increase in the budget deficit, in order to spend more on infrastructure and public
services. Many believe that the government is still maintaining fiscal prudence, even though it has
dropped its goal to balance the books by 2020. They still want a balanced budget. Just not now.

Economic stimulus, in the form of tax cuts or government expenditure, ought to offset some of the
hit to growth that the Brexit vote could bring about. However, supporting the economy in this way
comes with a cost. If the additional borrowing does not boost growth sufficiently, it could make
the government more indebted, raising the national debt share.

The Organisation for Economic Co-operation and Development has calculated that raising public
investment in the world’s 34 advanced economies by 0.5% of their national output each year over
two years would pay for itself through higher growth in the UK, US, Eurozone and Canada.
However, large investment projects can also take time to get started. Instead, Danny
Blanchflower, a former Bank of England policymaker, says that cutting VAT from 20% to 15%,
would be something the Chancellor ‘can do tomorrow’, offering an immediate kick-start to
consumers and businesses.

Source: The Telegraph, 26 July 2016.

Article 2: UK Budget 2017, economic forecast and Brexit uncertainty

Philip Hammond has delivered his first budget since taking over the role of Chancellor of the
Exchequer after the UK’s Brexit vote. He has unveiled a brighter outlook for economic growth,
with an upgraded forecast for growth in 2017 from the Office for Budget Responsibility. He spoke
of job creation and wage growth. And, with public finances in better shape than expected, he was
also able to report lower borrowing forecasts.

But recent history shows us why we should not be so confident about all these healthy forecasts.
A look at the recent history of economic forecasting makes the upgraded expectations of 2%
growth in 2017 questionable. Deriving forecasts about the state of the UK economy and public
finances is a huge challenge – in general – but especially now that we do not know how the UK’s
relationship with Europe will shape up following Brexit. Indeed, forecasts in the past usually turned
out to be wrong. For example, during the 2008-2009 financial crisis, GDP fell earlier and more
sharply than policymakers thought at the time. Since 2015, provisional GDP growth data seems
to be sending the rather misleading signal that the economy is doing better than it actually is. The
Office for Budget Responsibility (OBR) – the UK’s fiscal watchdog – has warned that
‘governments should expect nasty fiscal surprises from time to time – because discretionary policy
can only reduce risks, not eliminate them.’
Irrespective of what Mr. Hammond’s thinking might have been, the health of the UK public
finances critically depends on the country’s economic performance. This is hard to pin down.
Indeed, provisional published GDP data are often revised quite dramatically down the line. This
is more the case in periods of increasing uncertainty – such as the recent financial crisis and the
present volatile economic climate following the recent Brexit vote.

Source: Newsweek, 9 March 2017.

(a) (i) What is your understanding of the term ‘discretionary fiscal policy’?

(ii) How are tax cuts and a rise in government expenditure supposed to ‘offset some of
the hit to growth that the Brexit vote could bring about’ (Article 1)?

(b) Using the concept of ‘automatic stabilisers’, explain why ‘the health of the UK public
finances critically depends on the country’s economic performance’ (Article 2).

(c) It is reported in Article 1 that the Treasury has been running years of fiscal austerity to
reduce growing national debt. However, it might now ‘loosen its purse string’ in response
to any slowdown caused by the UK’s decision to leave the European Union.

Critically evaluate whether this move makes good policy sense.