growth but still remains at approximately 1.5% of potential GDP.

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1 THE UK ECONOMY IN FOCUS/APPLICATIONS Reminder of key objectives: Low and positive inflation (inflation rate target of 2%/- 1%) Sustainable growth of real GDP (no target) falling unemployment (no target) higher average living standards improved competitiveness/trade balance (no target) a more equitable distribution of income improved public finances Major indicators Real GDP: 2008/9 GDP fell; negative growth rate (recession). Since then growth has been positive but slow. It was only after the end of 2012 that growth picked up; 1.4% in 2013, 2.4% in 2014 & 2.3% in This recovery is much smaller than the recovery of previous recessions, e.g after the 80s recession the economy recovered by 9.2%! The major drivers of recent growth have been increases in consumption and a smaller increase in exports and investment (in 2014). The UK economy still remains an unbalanced economy in that growth is too dependent on consumer spending. Please read the article at the back, Questioning the UK recovery. Output gap: there has been a negative output gap since 2008 which has fallen with recent growth but still remains at approximately 1.5% of potential GDP. Unemployment: reached its peak in 2011 at 8% but has since fallen to around 5% (February 2016). Note there is a delayed effect between growth and the fall in unemployment, i.e unemployment is a lagging indicator of economic growth. Despite the reduction in unemployment, several million workers on part-time and/or zerohour contracts. Zero-hour contracts is indicative of the exploitation of labour, represents the triumph of the flexible labour market model. The living standards are still 2% below their all-time peak of ; the typical income of a 22-to-30-year-old has fallen 7.6% over the past six years, whereas that of someone over 60 has risen 1.8% (and there has been a gentle fall in living standards for those in the middle age group). Inflation rate: form the high inflation of 2011 (at 4.5%) to lower inflation recently (2.4% in 2014 to 0.3% in January 2016-expected to turn negative by spring 2016). Recently, however, the fall in the price of oil & foodstuffs as well as deflation in the Eurozone have contributed

2 to further reductions in the inflation rate to the point that this has raised concerns for deflation. The factors behind low inflation are: cuts in wages/low wage growth low inflation in other countries, e.g the Eurozone faces deflation right now the recent depreciation of the caused by fears of a Brexit and higher interest rates in the US Inflation is difficult to forecast because: volatile global energy prices changes in the value of the currency volatile food prices uncertain growth of aggregate demand Fiscal budget: a budget deficit that went from 11% of GDP in 2011 to around 6% in Expected to turn into a surplus by 2019/20. The reduction is due to mainly cuts in public spending, generally known as austerity measures, which were so severe that the budget deficit was expected to fall even more than it did. The major reason why the budget did not improve further is because tax revenues since 2012 fell despite the higher growth rates and fall in unemployment. This has been the result of creating new jobs that are significantly low-paid, e.g zero-hour contracts. The National Debt is high at around 90% of GDP which is actually lower than the average of advanced economies (109% of GDP). Current account balance: the balance has been in deficit for a long time now; from a high 5.1% of GDP in 2014, it still remains at about 5% in 2015; remains persistent and significant and, as a result, a cause of concern. Reflects lack of competitiveness and low productivity. Trade in services is in surplus and rising whilst trade in goods is in deficit and worsening. The exchange rate: a significant depreciation in 2008/9 in 2010/11, the appreciates another depreciation, smaller this time, in 2012/13 recently, 2015, the appreciates due to the crisis in the Eurozone over Greece early 2016 the is depreciating as a result of fears of a Brexit; also, due to the rise in interest rates in the US

3 Key supply-side challenges for the UK economy: persistent productivity gap high youth (16-24) unemployment, currently at 20.5%; major reasons are: 1. skills gap, 2. reluctant employers who may prefer older, more experienced workers, 3. Rise in retirement age that leaves fewer jobs for younger people, 4. Low business confidence low trend growth of GDP low investment and research deep regional divide rising inequality/relative poverty; UK is one of the most unequal developed economies Gini coefficient has been increasing since 2008, a sign of increasing income inequalities Examples of recent supply-side policies National infrastructure plan the idea is that high-quality infrastructure.g in transport, energy, technology, boosts productivity and competitiveness, allowing businesses to grow and enabling them to reach suppliers, innovate and attract inward investment. Infrastructure has the capacity to unlock economic potential in individual regions and ensure that growth and opportunities are distributed across the country, while also creating networks which bind together the different parts of the UK. Investment in infrastructure also helps the government to deliver new housing and business development where it is most needed. Corporation tax cuts 20% in 2015 from 21% in 2014 and 26% in 2011 Privatisation of Royal Mail Welfare caps - The Welfare Cap British Coalition government policy that caps the amount in state benefits that an individual can claim per year as well as the amount of overall welfare spending. This aims at improving incentives to work Shale gas tax cuts from 62% to 30% aim being to make the UK the leader in the shale gas revolution because it has the potential to create thousands of jobs and keep energy bills low for millions of people Patent box incentive This is a tax incentive introduced in 2013 designed to encourage companies to make profits from their patents by reducing the UK tax paid on those profits at around 10%. The aim is to further encourage spending on R&D. UK monetary policy: Since 2009, the base rate is at 0.5%. Quantitative Easing has totalled 375 bn. Under Forward Guidance ( ), the base rate will remain at 0.5% at least until unemployment

4 falls to 7% or until there are clear signs that the amount of spare capacity in the economy has reached normal levels. Given the slowdown of the Chinese economy, the BOE is not expected to increase the base rate any time soon; also it may again have to engage in further QE The housing market house prices fell during 2008/9 started to rise in 2010 fears of a new property bubble especially in London; rents at an all time high UK economy is affected by many external factors: slowdown or even recession in the BRICS & other emerging economies problems in the euro area; 45% of UK exports go to the Eurozone; the Brexit debate changes in global commodity prices fluctuations in exchange rates Article: Questioning the UK s Economic Recovery - Exam Style Jan 29, 2015 A lot has been made of the recent set of growth figures recently published of the UK economy. Despite the seemingly positive 0.5% quarterly growth and 2.6% annual growth, the overall impression is of disappointment and despondence. Many now believe that the UK economy is only partially on the road to recovery. Several obstacles remain on this path ahead and some are already slowing us down including: 1) Poor real wage inflation 2) Poor productivity 3) A ever bulging current account deficit 4) National debts at record levels despite 'austerity'. Austerity set to continue 5) Huge economic and political uncertainty in the Eurozone 6) Consumer and Business confidence no more than pre-crisis levels and increasing survey data showing how households' perception of their financial situation is far below pre-crisis levels 7) Long term and youth unemployment above pre-crisis levels 8) Private indebtedness at record levels manageable through record low interest rates

5 9) Banks remain unwilling to lend despite huge rounds of QE - Deflation risks putting banks off even more 10) National election uncertainty 11) Credit fuelled consumption the key avenue promoting growth. Manufacturing, construction and the trade sector are not contributing substantially to growth and in some senses are shrinking 12) A rise in interest rates which could cause our debt time bomb to explode These points make for excellent evaluation for an exam style question on the UK recovery. Here is an attempt to get students to see the light when it comes to transferring these real evaluation points on paper. Point (1) There are concerns that even though unemployment in the UK is falling, the long term unemployed are accounting for an ever increasing share of the unemployment figure. 36% of the unemployed have been unemployed for more than one year. A major negative impact of this is hysteresis where unemployment can lead to permanent unemployment in the future due to the loss of skills and human capital as that person becomes detached from the working environment. As a consequence, labour supply may be permanently lower in the medium term as growth picks up in the economy harming future potential growth curbing aggregate supply (a waste of resources) and aggregate demand through reduced incomes and spending. The recovery, therefore, may not be sustained. Point (2) Although growth has increased, real wages in the economy have yet to increase at any pace, that is wage growth beyond the rate of inflation. This is because productivity levels in the economy remain low and firms are not yet fully confident in increasing their costs when the economic climate is uncertain. Consequently, incomes and therefore spending in the economy maybe more subdued in the future if growth begins to slow halting the recovery. Point (3) To deal with mounting national debt, the UK government has implemented a strict deficit reduction plan which may conflict with UK economic recovery. This plan has involved heavy reductions in government spending accompanied by increases in taxation such a rise in VAT from 17.5% to 20% in Further austerity measures may reduce aggregate demand in the economy and reduce the chances of sustained economic growth and therefore recovery. Point (4) There are also concerns that UK growth is unbalanced with credit fuelled consumption still dominating. Personal levels of indebtedness are very high, corporate and public sector debt is also at record highs with this debt needing servicing. The longer the UK continues to grow based on borrowing, the more difficult it will be to sustain as money becomes more difficult to service and pay back. No where is this more evident than by looking at the UK s current

6 account position. Net trade is negative and has been negative for a large period of time and this deficit is growing. To finance this, the UK is borrowing large sums abroad adding to indebtedness. It is argued that for the recovery to be sustained, growth should be pursued from more investment and trade, which requires an improvement in international competitiveness. Evaluation Whether the UK recovery can be sustained depends on the nature of growth. If the UK economy is reliant on debt fuelled consumption to buy UK goods and services or imports (increasing the current account deficit), there is a risk that as interest rates begin to rise debts become so hard to service and repay that spending in the economy may grind to a halt. However if the UK can diversify and stimulate the trade sector, exporting more and importing less coupled with sustainable approaches to increase growth like increasing investment and productivity in the economy, these concerns may be limited. Judgement Based on the evidence, the UK economic recovery may well be sustained in the future. Inward growth from consumption as a result of higher incomes and falling unemployment will keep growth increasing as consumption is the major driving factor of UK GDP accounting for approximately 66% of growth. However there are significant risks to this recovery such as unsustainable levels of indebtedness, unbalanced growth and of real wages not increasing quickly enough which could scupper recovery if the UK suffers an unexpected economic shock, perhaps emanating from economic troubles in the Eurozone.