This comprehensive revision presentation by tutor2u Co-founder Geoff Riley is designed to provide support for AS Economics students (and their teachers) in the final stages of their revision for the Unit 2 paper on macroeconomics.
Preparing for the May 2012 Unit 2 Macro Paper Geoff Riley (tutor2u) April 2012
About the Author Geoff Riley Geoff is co-founder of tutor2u and Leader for Teaching and Learning Technologies at Eton College. Previously Geoff was Head of Economics at Eton College from 2000-2010 and Head of Economics & Politics at the Royal Grammar School, Newcastle. Geoff is also an experienced examiner and presenter at tutor2u student and teacher workshops. He continues to teach Economics and is also a leading proponent of using digital tools as a way of enhancing teaching and learning in Economics.For more revision Geoff is a newly elected Fellow of the Royal Society of Arts. He established a thriving Entrepreneurship Society whilst at Etonadvice for A Level College and for nine years ran the Keynes (Economics) Society. HeEconomics is also responsible for organising the teacher judging panel for thecourses, follow annual essay competition run by the Royal Economic Society.Geoff on Twitter Geoff has developed a specialist interest in the use of the Open web for educational purposes and is an expert user of Moodle, the popular open-source VLE platform. Geoff is a regular presenter at in-house inset training events for teachers.
Exam success is not a lottery! Know your terms Get the diagrams right Show current awareness
What really matters on this paper?• Determinants of macro performance – Understanding AD-AS analysis / changes in AD and AS – Using this analysis to explore recent and current developments and policies e.g. Recession and recovery• Analysing and critically evaluating a range of macroeconomic policies (e.g. MP, FP and SS-P) – How do policies work? The transmission mechanism – What are the limitations / constraints of each policy?
What really matters on this paper?• Understanding the external environment and how it impacts on the British economy (e.g. Events in Europe, the effects of globalisation)• Being aware of how the different macro topics link together – e.g. Inflation and unemployment, growth and trade, productivity and investment• Key is to show the examiner that you know what is actually happening in the UK economy
Macroeconomic performance and stability (1)• Domestic objectives: – GDP: Real economic growth (short and long term) – CPI: Price stability (low stable positive inflation) – Jobs: Achieving higher employment / less unemployment – Higher living standards (i.e. GDP per capita and other measures of well-being and social welfare, addressing inequality issues)
Macroeconomic performance and stability (2)• External objectives – Sustainable position on the current account of the BoP – Improving competitiveness in global markets• Restoring economic stability – Absorbing domestic and external economic shocks – Putting in place effective policies for stronger growth – Re-balancing the economy away from debt-fuelled consumption
Key Issue: Can the UK be re-balanced? Exports Invest ment Balanced recovery in Demand and Output The government wants higher exports and Achieving this looks harder investment to kick-start a than the coalition expected “balanced recovery”
A selection of re-balancing policies Currency depreciation • A boost to UK export competitiveness • Improved net trade balance (over time) • Higher exports creates positive multiplier & accelerator effects Supply-side support for industry • Reversing de-industrialisation • Establish more technology innovation centres • Increase graduates and apprentices in technical subjects Improving the supply of credit • Project Merlin • Plan for a credit easing scheme • Green Investment Bank for renewable investment schemes
Aggregate Demand (AD)• Total demand for domestically-produced goods and services• AD = Consumer spending (C) + Investment spending (I) + Government spending (G) + Exports of goods and services (X) - Imports of goods and services (M)
Trying to achieve macro stability Macro stability replaced by macro volatility in recent years
Another look at the cycleConsensus of economists is that the UK economy willexpand by 2.0% a year for the rest of this decade, abouttwo thirds the rate seen in the ten years prior to therecession
A permanent loss of output ??? Without effective policies / reforms and a stronger recovery in our trade partners – UK economic growth likely to be slower in the years ahead
Long term effects from recession• Fall in capital spending• Rising unemployment – Structural unemployment SLOW – Long term unemployment Growth• Continued credit squeeze – Less finance for exporters and Ahead business-start-ups– Rising inequality in income
Trend growth is falling – why? Recession may have inflicted damage on trend growth
The output gap is negative Inflation has averaged over 3% since 2008 No change in policy base rates for over 3 years Plenty of spare capacity
Household demand is main short termdriver of AD. Weak consumption in 2009and again now – lots of causal factors –living standards are falling for most workers.While inflation has risen to 3.5%, averagepay rises have fallen to 1.1%
What is causing falling consumption? Credit still in short supply – and expensive People need to save and pay back debt UK housing slump – falling asset prices Rising unemployment – now above 2.7 million Low consumer confidence Falling real disposable income for millions Lots of things in macroeconomics are multi-causal!
Stagnant house pricesFalling prices - known asasset price deflation Average UK house prices are 25% below their peak in 2007 The average deposit required for a mortgage is £38,000 – tough to find
Consumer confidence remains weak Recession caused steep drop in Sentiment now being held back by consumer fiscal austerity + persistent high confidence inflation and rising unemployment
Steep fall in capital spending duringthe recession – how can this bestimulated? Key to long term growth Mis-leading for many businesses who pay way above the base rate
Analysis: What factors affect the level of capital investment spending? Expected Actual & profits and expected business demand taxeseExpectations matter in Interest rates + Businessmacroeconomics! availability confidence of finance
Jobs and prices Worsening trade off between 2 key macro objectives
Does the UK have an inflation problem? CPI inflation has been above the 2% target for most of the last four years Analysis: Lower inflation in 2012 should increase the real value of consumers incomes
Showing demand-pull inflationPrice Level Demand pull inflation occurs when AD rises and SRAS is inelastic i.e. The output gap is positive SRAS P2 P1 AD2 AD1 Y1 Y2 National Output
Showing cost-push inflationPrice Level A fall in SRAS might be caused by higher costs of production – leading to lower supply at each price level SRAS2 SRAS1 AD1 Y2 Y1 National Output
Oil prices affect AD and SRAS Global oil prices have risen strongly after the recession – comfortably above $100 a barrel – with big effects on businesses and consumersThe external environment matters a lot for the UK economy
Is 4% inflation a problem for the UK? Objectives: Don’t kill off the recovery • Need stronger growth now rather than higher inflation • 4% inflation is not high looked at long run context 4% inflation may not last! • Much of rise in inflation is temporary • Due to external factors e.g. Oil and food prices A little extra inflation can be good! • Helps to reduce the real value of debt • Rising revenues and profits for some businesses
8% of labour force out of work & rising Economy needs to grow at least 2% forDeep recession (> 6% fall in unemployment tooutput) and weak recovery start falling(GDP grew only 0.7% in 2011)
Unemployment rose sharply duringthe recession and is growing oncemore – a worrying sign
Unemployment is much higher in someof Europe’s economies.Youth unemployment in Greece andSpain is over 50% of the labour force
Long term youth unemployment More than a million young people are now unemployed across the UK. 225,000 have been out of work for at least a year Long term youth unemployment has more than doubled since the start of the 2008 recession
Analysis: Explaining high youth unemployment – 16-24yrs Human Reluctant Capital Employers (skills) – less new Deficit jobs Reduced Weaknessretirement of existingrates limit training chances schemes
Targeted stimulus policies to boost labour demand Expansion of apprenticeship schemes Housing reforms to improve geographical mob Measures to stimulate business start-ups Active regional growth & development policies
3 Years of 0.5% Base Interest Rates Lower interest rates is an easing or relaxation of monetary policy The UK’s Bank of England has now kept the cost of borrowing at 0.5% for three years
How changes in interest rates are supposed to affect demand and pricesChange in market interest rates Impact on aggregate demand (C+I+G+X-M) Effects on output and jobs & investmentTime Lags – might take 1-2years for full effect to happen Feeds through to Real GDP and Prices
Factors limiting effects of low interest rates Businesses Weakness in Deleveraging Fragile cash economies in the UK Consumer hoarding of our major financialand Business despite trading system – Confidence rising profits partners cutting loans
Defending the Bank of EnglandPrompt action in 2008-09 avoidedsustained deflationCuts in policy rates & QE hasavoided deep depressionSome re-balancing of UK economynow happeningCrisis was unprecedented – a oncein lifetime shockDifficult for low policy rates towork in a liquidity trap
Quantitative Easing (QE)QE is a deliberate expansion of the central banks balance sheet and themonetary base – electronically creating money to improve liquidity in banking
By February 2012, the Has QE Worked?total size of the QEprogramme was £325bn Lower yields on bonds saves government money Useful policy when fiscal policy is being squeezed Bank lending is still weak – risk averse banks
25% depreciation in sterling v US$ Low stable pound for last three yearsHas the fall in sterlingbeen of benefit to theUK economy?
Has a weaker pound helped the UK economy? Export boost – injection of AD A stimulus for British industry Foreign investment into UK has grown
Limits to the impact of a cheaper currency Higher import prices and increased cost-push inflation Businesses are finding it hard to get export finance from the bank Recession in main UK export markets including the Euro Zone Competitiveness is not just about cost and price – innovation / design counts
Growing trade surplus in servicesTrade deficit in goods close to £100b
Key services: Business services Financial services Transport and tourism Education and Health Creative industries Research and developmentKey goods:Manufactured goodsOil / gas / mineralsFood and drinkComponents
Why does the UK economy still run such a large trade deficit? High income elasticity of demand for imported goods and services Some weaknesses on supply-side of the economy (i.e. Research / investment) Many UK businesses are finding it hard to finance a rise in exports (credit squeeze) The majority of our exports go to slow- growing countries in Europe and USA
Fiscal PolicyThe big issue in fiscal policy is thedecision by the Coalitiongovernment to introduce a periodof fiscal austerity – i.e. Cutting the G>T =budget deficit through spending budgetcuts and tax rises deficit
Govt Spending has macro & micro effects and demand and supply-side effects!
Taxes also have microeconomic effects! And demand and supply-side effects
How much borrowing can the UK take? Government debt is rising but long term bond yields remain low Fiscal austerity as Coalition aims to cut the size of the budget deficit over the next five years – will the pain work?
The UK government can borrowmoney for 10 years at cheap interestrates (around 2%) – whereas the costof borrowing for other countries issignificantly higher – this gives the UKan advantage – has it been used well?
The case for budget deficit reduction• High debt threatens stability and recovery• Government wants credibility in financial markets• Higher future taxes will squeeze the private sector• Inequitable to leave future generations with debt• Doubts about effectiveness of stimulus policies
Counter-arguments to fiscal austerity• UK should take advantage of low interest rates to fund much needed infrastructure• Economy is depressed and unemployment is high. Spending is needed to create jobs• Sensible fiscal stimulus policies are self-financing – they create extra tax revenue over time• Poor households and families with children will bear the brunt of austerity – it will make inequality worse
The UK economy is exposed to many external demand shocks1. A big rise or fall in the sterling exchange rate2. Recession in major trading partners which affects the demand for exports e.g. Euro Zone crisis3. A prolonged slump in the housing market4. Continued credit crunch 1. Squeezing supply of loans – impact on businesses and consumers 2. Making it harder for export businesses to take advantage of the competitive exchange rate
BRICs growthEconomic growth in the BRICcountries is slowing down but isstill higher than for advancedWestern nations. How would asharp slowdown in China affect theBritish economy? Can you findsome connections?
A fall in aggregate demandPrice Level An initial change in AD can have a much greater final impact on equilibrium national income. This is known as the multiplier effect AD2 LRAS AD1 SRAS Y1 Y2 Real National Output
Multiplier effect is strongest when SRAS is elastic and when AD risesPrice Level An initial change in AD can have a much greater final impact on equilibrium national income. This is known as the multiplier effect AD2 AD1 SRAS Y1 Y2 National Output
Supply-side shocks• Supply-side can be affected by shock effects• Not all shocks are negative for growth, prices and jobs• SRAS: – Changes in global food prices – Volatility in the prices of imported raw materials / energy – Changes in import tariffs and other import controls – Changes in indirect taxes on businesses and subsidies• LRAS – Impact of new technologies on costs and productivity – Long term impact of innovation and invention – Unexpected changes in the size of net labour migration
Analysing “economic shocks”• Make good use of AD-AS analysis (use your AS economics!)• Consider short-run and possible longer-run effects – 1/ First round effects (immediate or short term) – 2/ Second round fallout (medium term effects – can be positive or negative)• The impact of shocks will vary from country to country• How big is the shock?• Is the shock temporary or more persistent?• Consider how economic policy might respond to the shocks• How much freedom to change policies do countries have?• Use your economic knowledge – keep up to date!
Where will economic growth come from? Labour Innovation Productivity Capital Market andImprovements investment Participation Enterprise
Assess the policies that might be most effective in achieving faster economic growth in the UK over the next few years• Fiscal Policy – Employment taxes e.g. Cuts in national insurance – Reduced taxes on lower-paid jobs – Incentives for green investment – Youth training guarantees – Fast-forwarding capital projects e.g. Transport – New house building – Revising deficit reduction plans (less austerity)
Assess the policies that might be most effective in achieving faster economic growth in the UK over the next few years• Monetary Policy – Credit easing programme – Intervention in currency markets• Supply-side Policies – Attacking the infrastructure deficit – Migration policy (e.g. Caps) – Enterprise policies – Green Investment Bank – Relax planning for construction
The LRAS curvePrice Level LRAS is assumed to be independent of the price level and is drawn vertical LRAS LRAS curve AD1 represents the normal capacity level of the economy SRAS1 Y1 Yfc National Output
An increase in productive potentialPrice Level An increase in the supply-side capacity of the economy is shown LRAS LRAS2 by shift in LRAS AD1 SRAS1 Y1 Yfc Yfc2 National Output
Some examples of applying AD-AS diagrams• How changes in interest rates affect AD and inflation• How changes in taxation might impact on LRAS• How movements in the exchange rate affect AD & AS• Impact of supply-side policies to stimulate enterprise• Economic consequences of labour migration• Effects of changes in import tariffs and quotas• Multiplier effects from economic stimulus policies• Analysing the impact of the credit crunch / recession• Analysing the causes of higher cost-push inflation
Remember the Wee-Steps Approach Wider context – consider the bigger picture in an issueW and use it to weight your arguments Efficiency – Does this achieve a more/less efficientE allocation of resources? Equality – Do some parties benefit more/less than othersE from a policy change? Scope – How many people are affected by the point? Is itS wide reaching or narrow?T Time – How long will it last, SR or LR or both? Effectiveness – does it solve the issue it was intended toE solve? Are there better alternatives? Prioritisation – which of your points is the strongest andP why. Be specific about the context of the question – use this in your final paragraph Scale or Magnitude – where people are affected howS strong is the impact?
Improving your Macro Evaluation (1)1. Most macro problems have multiple causes2. No single macro policy works in isolation3. Combination of policies needed for short & longer term 1. Demand side policies and supply side policies 2. Be clear on the main ideas behind Keynesian macro theory4. Remember – economics is a social science – we can never be certain about how people will respond
Improving your Macro Evaluation (2)5. Expectations and confidence are crucial – e.g. Weak animal spirits during the early stages of a recovery6. Policy time lags are uncertain e.g. The time lag between economic recovery and falling unemployment7. Use data to support or reject a point of view8. Question reliability of the data – especially if out of date
Macro Evaluation (3)• Importance of macro awareness / knowledge 1. It is crucial that you show an awareness of what is actually happening in the British economy 2. Use the extracts in your answer – make at least three explicit data references in your final answer (from charts, table and text) 3. Also show awareness of events / issues in other countries – useful for comparative illustrations e.g. Events in the USA, Europe, China• AD-AS analysis must always be used as foundation to show impact on output, prices, employment• Remember to offer a clear final conclusion in the essay questions at the end of the data response paper
The best evaluation answers in AS macro papers Make good use of data provided Start with clear and accurate analysis Provide some real-world context Cover a range of different policies Consider short run + long run effects Ask whether a change is significant Are aware of the limits to policies End with a reasoned conclusion