1 Government Macro Objectives and Indicators of National Economic Performance

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2 1 Government Macro Objectives and Indicators of National Economic Performance 1.1 Circular Flow of Income The circular flow of income model illustrates economic activity between economic agents The difference in micro & macroeconomics is Macroeconomics studies aggregate or total behaviour ie how all consumers, firms the government and overseas economic agents interact. Microeconomics considers how individual firms and consumers behave in individual markets, why markets work and fail What does macroeconomics study? List Government macro objectives What are economic sectors? Macroeconomics is concerned with the study of the economy as a whole and in particular: Economic Growth: what factors causes increases in Gross Domestic Product (GDP) hence living standards. The causes and consequences of unemployment why are some workers seeking employment, jobless? Inflation: reasons why general prices rise persistently and associated problems International trade: does the UK pay its way in trading with other countries? Why do exchange rates fluctuate? Economic cycle: why does the economy move in a regular cycle of booms and slumps? The government is responsible for managing the economy. Government macroeconomic objectives include low and stable inflation & unemployment, high & sustainable economic growth, a satisfactory balance of payments and an acceptable distribution of income For the purposes of analysis, the economy is divided up into four sectors: Households receive payments (income) for their services (eg labour) and then buy the output of firms (consumption) Firms hire land labour and capital (resources) owned by households to produce goods and services for which they pay wages rent etc (income). Firms receive payment (expenditure). Firms invest (I) in new producer goods Government collect taxes (T) to fund spending on public services (G) International The UK buy overseas products, imports, (M)) and overseas economic agents buy UK products, exports (X) Govts also seek stable exchange rates Economists sometimes refer to households, firms the government and overseas sector as economic agents What is the circular flow of income model? The circular flow of income (CFY) illustrates economic activity in a given time period. It identifies the main sectors in the economy (households, firms the government and overseas) and linkages between sectors eg wages, government spending & interest payments The real circular flow of income shows flows of goods and services and factors of production between firms and households. The money circular flow of income shows the flow of money to pay for economic activity. Households receive payments for their services (income) and use this money to buy the output of firms (consumption). Income Y Households Money Circular Flow of Income Firms Consumption C Leakages or withdrawals Savings S Taxation T Imports M Injections Investment I Government G Exports X Use the circular flow of income model to illustrate 1) Economic activity 2) Components of AD Income expenditure & output methods ie NY = NEx = NQ, and 3) Multiplier effect Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 8

3 1.1.6 What are flow and stock values? A flow value is an amount per period of time eg the UK produces 900Bn worth of goods and services each year. A stock value is an amount at a given moment in time eg UK at the end of 2002 UK firms held 5Bn worth of stocks What are injections & leakages in the CFY model? A leakage (withdrawal) from the CFY is when part of earned household income is not spent on final goods. Consumers Keep some income for future spending saving (S) Use part of their income to pay government tax (T) Buy foreign made products ie imports (M) An injection into the CFY occurs when firms supply products to non-household sectors. Firms receive income from selling to Other firms, ie investment expenditure (I) The government, ie government expenditure (G) Foreigners, ie export expenditure (X) In equilibrium flows out of the CFY are counterbalanced by flows back in What is consumption Consumption (C) is spending by UK households on UK made goods and services What is investment Investment (I) is spending by UK firms on capital goods such as new factories, plant or buildings, machinery & vehicles Define net investment Production results in capital consumption machines become worn out and obsolescent. Net investment only occurs after such depreciation of fixed assets is taken into account. Net investment = gross investment - depreciation Govt spending is Government (G) is spending by the UK government on public services eg NHS doctors salaries & new equipment for state schools Define imports & exports What factors determine consumption Imports are products a country buys from other nations. Exports are domestically produced items sold abroad. In the CFY: Imports (M) is spending by UK residents on goods and services produced overseas Exports (X) is spending by overseas residents on goods and services produced in the UK Net exports (X-M) is the difference between a country s income earned from exports and total spending on imports The main determinant of consumer spending is disposable household income. An increase in income usually increases consumption. Other influences include interest rates, consumer confidence and house & share prices. Resources can be used to create items for immediate use (consumption) or to create producer goods that increase future productive potential Marginal propensity to consume What factors increase investment Govt spending depends on? What factors determine net exports Main components of UK spending The marginal propensity to consume (mpc) is the proportion of extra income spent on consumption: The proportion of extra income spent (mpc) declines as household get richer because consumers are more able to save Lower Interest rates, new technologies, corporation tax cuts, improved business confidence in a booming economy where firms are operating close to capacity, encourage investment. The higher national income (GDP), the more taxes paid to government and the greater its ability to spend on public services. A slump reduces income tax & corporation tax revenues forcing the government to make cuts or borrow to maintain services Spending on a country s imports or exports is affected by incomes at home (M) & abroad (X), relative prices, relative quality (design, reliability & after-sales service) of products, the level of the exchange rate and the degree of trade restrictions eg tariffs & quotas Households Government Firms Overseas Gross I Stock changes Exports Imports GDP % of GDP 70% 18% 18% 0% 34% 40% mpc = C/ Y and falls as income rises Interest rates are the cost of borrowing for I Demographic changes eg aging pop also affect G UK Annual Spending by Sector GDP at constant 1995 prices ( bn) Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 9

4 1.2 Calculating National Income Economic activity is? Economic activity refers to the production, distribution exchange or consumption of goods and services What is national income? What is Gross Domestic Product? National income (NY) is the monetary value of goods and services produced in an economy in a given time period, usually the last 12 months. NY estimates the value of products available to a country from its economic activity. Measures of national income include Gross Domestic Product (GDP) & Gross National Income (GNI)UK GDP in 2004 was 1,109,574Bn Gross Domestic Product the total value of final goods & services produced within a country's borders in a year. Note: gross: depreciation of capital is not subtracted; Product: only final output is included; domestic: only output within a country is counted What is Gross Gross National Income (GNI) is a broader measure of national income than GDP. National Income? GDP measures the value of economic activity within the territory of the UK over a period of time GNI measures the value of economic activity by UK citizens anywhere in the world over a period of time. Cars produced by Honda in the UK are included in UK GDP but profits sent back to Japan add to Japan s GNI. The ONS defines national income as gross national income: the income available to the residents arising from GDP, and receipts from, less payments to, the rest of the world of employment income, property income and current transfers Why increase GDP A rise in real GDP (economic growth) means a more output and improved economic welfare as more wants & needs can be satisfied What is national income accounting? Why is national income calculated? How is national income estimated National income Accounting (NYA) is the process of trying to estimate the monetary value of goods and services produced in an economy, in a given time period, eg a year. Measures include Gross Domestic Product (GDP) and Gross National Income (GNI) Measuring the monetary value of goods and services produced within a country (GDP) or by its citizens (GNI) allows economists to evaluate UK economic performance eg calculate economic growth, changes in standard of living & income distribution, over time. The Office of National Statistics (ONS) estimates national income (NY) using three alternative but complementary approaches: Income method: add up the incomes earned from the current production of goods and services Expenditure method: add up the money spent on all current finished goods and services, less the cost of imports Output method: add up value added by every firm or the value of final current UK output. Intermediate output is ignored Define value added Value added is the difference between the value of a firm s inputs (items firms purchase) and their output (items firms sell). Value added measures a firm's contribution to GDP Give an example of value added Stage of production Input ( ) Output ( ) Value Added Wheat Farmer Flour Miller Baker Supermarket Final consumers The money spent on making goods (inputs) is taken away from the money received from the sale of items (outputs) to give value added. Taking final output or adding up each sector s value added gives national income. Wheat, flour and bread supplied to the supermarket are examples of intermediate output and are ignored in NYA The value of loaves sold by the supermarket to the consumer gives final output and this figure is included in NYA The level of national income indicates the size of the economy. GDP is the most common measure of national income GDP is a monetary estimate of the total amount of economic activity within a country in a given time period. GDP is estimated by totalling up a country s output, income or expenditure in a year. GDP & GNI are different ways of stating a country s national income ie the monetary value of its total output in a year Each method of estimating GDP is imprecise and contain errors & omissions that give different rent results. Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 10

5 The main problems of using the output method The main problems of using the income method Current & capital expenditure Problems of using the expenditure method Effect of inflation on national income How are inflationary effects eliminated? What is real and nominal GDP? How is real GDP calculated? Intermediate output is goods & services used in making the final finished product eg raw materials, components & transport. Final output is items sold to the customer. Including intermediate output in national income results in double counting eg the value of flour, etc would be counted once when sold to the baker, and again when the loaf is sold to the consumer. Over time, the quality of products may improve and prices fall. For example computers get faster and cheaper The income method only counts incomes earned in return for providing a good or a service. This means: Non-marketed output the value of DIY, unpaid housework and voluntary activities do cause an official incomeexpenditure flow and so are not recorded in official NY figures. Subsistence farming in less developed countries (LDCs) does not result in an income and so form no part of official NY figures. GDP figures for LDC understate economic activity Transfer payments received for no corresponding output (eg unemployment & child benefits) must not be counted Undeclared economic activity in the informal economy means official figures may underestimate true GDP by up to 13% Current expenditure is spending on items that only last a limited period of time. Products are consumed in the current time period ie this year. Capital expenditure is spending on producer goods that items that last and are used to help create products in future years ie investment Adding up the money spent buying current output gives an inaccurate value of national income. GDP at market prices includes indirect taxes & subsidies. Deducting indirect taxes & subsidies gives GDP at factor cost a more accurate valuation of NY Second-hand goods also pose a problem as they have already been counted. If a second hand car is bought for 5000, serviced & repaired and then sold for 8,000, only the value added created in the current time period is counted in NYA ie 3,000 National Income has a price and a quantity component. If the price level doubles with the same amount of goods and services produced, then nominal national income also doubles but real national income remains constant. Inflationary effects are eliminated by valuing current output at constant prices ie by calculating each year s GDP using base year prices. UK GDP values in the table below are valued at 2002 prices GDP is measure in both real and nominal terms. Real GDP is a better indicator of economic performance because it strips out the effects of inflation. Nominal or money GDP is current output measured at current prices eg 2006 output valued at 2007 prices. Real GDP is current output valued at constant or base year prices eg 2006 output valued at 2002 prices (where 2002 is the base year) To calculate real GDP use the formula Real GDP = Nominal GDP x CPI in base year/current CPI Eg if nominal GDP is 900Bn and the CPI = 200 then real GDP = 900Bn x 100/200= 450Bn What is current GDP Year GDP at constant (2002) 1,005,542 1,027,905 1,048,456 1,074,858 1,109,574 market prices ( ms) Growth rate %pa 2.2% 2.0% 2.5% 3.2% n/a Constant 2002 prices means output in all years are both being valued at 2002 prices ie any inflationary effects are removed Chained volume Chained volume measures refer to data sets where the level of prices is held the same for all years. Figures measured in today's prices (current prices) have been deflated by the change in prices since a particular reference or base year What is the standard of living? The standard of living refers to the average amount of GDP for each person in a country ie per capita real GDP. It is found by dividing real GDP by the size of the population. Statisticians ignore intermediate output & count only value added or final output The informal economy refers to economic activity undeclared to the government resulting in lost tax revenue. Base year is the reference year of data set eg 2002 CPI: consumer price index - base year is 2005 The effect of price changes is excluded Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 11

6 Does GDP measure welfare? Can GDP be used to make comparisons of SoL between countries? What are the limitations of national income measures of economic performance? What is economic development Is growth economic Development? What is sustainable development? How is economic development measured? National income statistics simply measure changes in output. GDP figures do not take account of: negative externalities and sustainability issues associated with increases in economic activity Lost leisure and increased stress if GDP increases because people are working harder and longer hours Inequality issues such as national and region income distribution differences equity issues GDP places a monetary value on the amount of goods and services created by a country in one year and so can be used to make economic comparisons between countries. However raw GDP figures will need adjusting for: Divide GDP by the size of population to establish standard of living (SoL) ie average GDP per person, Inflation (use real not nominal) and exchange rate effects (convert local currencies into a common currency ie $) ie use purchasing power parity PPP$. Even then per capita real PPP$ ignores issues such as size of informal economy, length of work week, extent of externalities, sustainability, and income & regional inequality factors Economists are criticised for over emphasising economic growth as the indicator of performance. GDP is a narrow measure of economic welfare. Economic development requires improvements in growth and broader indicators of human well-being eg: A reduction of poverty, inequality and unemployment. Less stress and shorter working hours allowing more leisure. Improvements in life expectancy, educational attainment, individual self esteem, expanding economic & social choice Economic Development requires sustainable economic growth and improvements in other indicators eg a reduction in poverty, inequality and unemployment and improvements in life expectancy, educational attainment and other indicators. Economic growth is not necessarily economic development. GDP is a narrow measure of economic welfare that does not take account of key non-economic aspects eg life expectancy, access to health & education, environment, freedom or social justice. Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs. Brundtland Report The UN has developed a widely accepted set of indices to measure development against a mix of composite indicators: UN s Human Development Index (HDI) measures a country s average achievements in three basic dimensions of human development: life expectancy, educational attainment and adjusted real income ($PPP per person). UN s Human Poverty Index (HPI) measure deprivation using % of people expected to die before age 40, % of illiterate adults, % of people without access to health services and safe water and the % of underweight children under five Economic development is best measured by broad composite indices such as the HDI Dollar purchasing power parity exchange rate ($PPP) adjusts exchanges rates to ensure $1 buys the same quantity of products in each country. GDP figures can be misleading and reflect only one dimension of development. Sustainability: the ability to continue. Sustainable growth is just one aspect of development. Development results in higher GDP and less poverty, inequality and unemployment; improved SoL, life expectancy, educational attainment, & social choice Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 12

7 1.3 Economic Growth Define economic growth How is economic growth measured? What is the UK s average growth rate? What is the opportunity cost of economic growth? Economic growth is an increase in the capacity of the economy to produce goods and services, and can be illustrated by an outward shift in the production possibility boundary. The economic growth rate is the percentage increase in real GDP over twelve months. The rate of economic growth is the percentage increase in real GDP over twelve months. A 1% growth rate means standards of living double every 72 years; 2% 72/2 = 38; 10% = 72/10 = 7.2 The UK s average growth rate for the last century is 2.4%. This means, year on year, the UK economy is producing 2.4% more goods and services than 12 months earlier. British standards of living typically double every 30 years. Economic growth is achieved by increasing the: quantity of resources through investment the quality of resources through training improving technology and the use of existing resources The government of a developing country just meeting its essential needs may chose to reallocate resources from the production of consumer gods to investment goods. The economy moves from A to B The short run opportunity cost of HG extra investment is ED lost consumer goods possibly essentials. People may starve for extra producer goods Capital Goods T L H G D Process of Growth using PPBs B E A M V Consumer Products Economic growth is a rise in real GDP. Opportunity cost measures the cost of an economic choice in terms of the best alternative foregone. Production possibility curves are an effective method of illustrating the process, opportunity cost and outcome of growth What are the consequences of economic growth? The potential advantages of growth include: More products to satisfy more wants & needs Higher employment allows higher wages so that poverty is reduced. Workers earn higher incomes for producing more goods and services Bigger tax receipts rise allowing more public services The potential disadvantages of growth include: Environmental Increased pollution from increased economic activity Sustainability Depletion of non renewable natural resources may be unsustainable and threaten the well being of future generations Equity benefits may be narrowly distributed to the rich Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 13

8 1.4 Productivity The supply side is? The supply side refers to factors affecting the quantity or quality of goods and services produced by an economy eg productivity Production is Production is the value or volume of output (Q) in a given time period How is productivity measured? What determines labour productivity? How is UK economic performance measured? Productivity is the amount of output produced per unit of input. Labour productivity refers to output per worker and is found by dividing total output (Q) in a given time period (eg a week or hour) divided by number of workers AP= Q/L. The amount of output produced by one worker depends on a) the skill & training of the labour force b) the quantity and quality complementary factors eg machines, building which can be improved with investment and c) the quality of management and leadership. Low productivity is caused by a combination of poorly managed, under trained, workers using outdated machinery. The main measure of UK performance is productivity ie is the amount of output produced per unit of input. The UK s standard of living is determined by productivity. International Competitiveness ie productivity levels between different economies. Productivity is a key determinant of overseas competitiveness Productivity determines prosperity Is the UK competitive The UK has lower productivity than competitor nations such as the USA Germany or France there is a productivity gap Why does the UK have a productivity gap? What is the impact of an increase in investment? Skills good at the top (eg Oxbridge) but poor at the bottom (22% functional illiteracy rate). Low skill levels reduce economic performance. Too many workers lack the key basic and intermediate level skills. DTI Solution: Education & training Investment The level of business investment still remains below that of our major competitors. DTI Solution: improve incentives for investment especially in ICT & communication Innovation requires spending on Research & Development (R&D). The UK has global scientific excellence that attracts FDI. However UK firms are undertaking less R&D than their competitors. Solution: improve incentives for R&D Enterprise UK staff are more risk adverse than USA counterparts ie they prefer to accept tenured employment rather than start a business. Solution: improve incentives for risk taking eg lower corporation tax & capital gains tax for small firms Competition The UK has flexible & efficient labour market and the lowest unemployment rate in the G7 Investment affects both the demand and supply side of the economy. More investment stimulates aggregate demand and generates a multiplier effect. Also a country s productive capacity increases with new and better machinery allowing higher productivity. I also affects the supply side of the economy Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 14

9 1.5 Government Macroeconomic Policies & Objectives Governments have macroeconomic objectives and use policy instruments to achieve these aims. Incomplete & inaccurate data, time delays and unexpected external shocks make managing the economy difficult. Moreover objectives can conflict. The application of macroeconomic policy is covered in depth in Section 3 of these notes What are The government s macroeconomic policy objectives for the economy is to improve the country s economic welfare through government policy Low & stable inflation within 1.0 to 3% pa range Higher levels of investment and productivity objectives for the Maintenance of low unemployment Satisfactory balance of payments macro-economy High and sustainable real economic growth Acceptable distribution of income What is the current Government's economic strategy Distinguish between internal and external objectives Why do governments set objectives Delivering macroeconomic stability by ensuring the golden and sustainable rules met Improving productivity ie increase in Q/L Increasing employment opportunity for all with, ideally, full employment; Ensuring fairness for families and community ie acceptable income distribution and a fall in relative poverty (numbers living on income below 60% of average median income) Protect the environment. Objectives are quantified eg the inflation target is met if prices rise within the stated target range of 1.5 to 2.5%; ensuring fairness if numbers of those living in relative poverty fall to X million Internal economic objectives: controlling price inflation, maintaining high employment and sustainable economic growth External objectives: the balance of payments and in particular the current account and exchange rate Objectives enable evaluation. A government has a successful economic policy if the stated objective is met by the end of the stated time period. Eg inflation held at 2%, full employment achieved. Inflation exceeding the target means an unsuccessful economic management of the economy by the government. Source: The Treasury How does a government seek to meet its objectives? What is demand management? Why are policies needed? Policies to Reduce Poverty Government attempts to achieve its macroeconomic objectives using macroeconomic tools or policy instruments : Demand management policies - measures to change AD eg fiscal, monetary and exchange rate policy Supply side policies measures to change AS eg measures that improve product and factor (eg labour) market productivity Demand management occurs when the government attempt to influence the level of aggregate demand (AD) hence the levels of national income, employment, rate of inflation, economic growth and the balance of payments position. Reflationary policies to increase the level of AD to at, or near, the level of potential GDP Deflationary policies decrease the level of AD to at, or near, the level of potential GDP. New products & technologies, changes in taste, world booms & slumps, volatile oil prices, etc means the UK economy continually has to adjust to shocks. Macroeconomic policies enable the govt to influence economic activity to achieve set objectives Governments seek to reduce relative poverty by redistributing income via the tax and benefits system eg progressive taxes and means tested grants to Reducing unemployment hence poverty eg Welfare to Work & Sure Start scheme increase employment and household incomes Legislation eg National Minimum Wage Demand & supply side polices are linked eg changing benefits affects consumption and incentives to work Economies are inherently unstable Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 15

10 1.6 Economic (Business) Cycle Define the economic cycle The economic cycle is when actual GDP tends to move up and down in a regular pattern causing booms and slumps (depressions), with recession and recovery as intermediate stages Actual GDP is Actual GDP is the level of output produced by an economy in a given year Potential GDP is? Potential output: the maximum level of real GDP in a given year consistent with stable inflation. All markets are in equilibrium eg all labour seeking jobs at the going wage rate can find work. Actual GDP may diverge from potential GDP causing output gaps Sometimes called the business cycle Measures maximum sustainable output Trend growth is Trend growth is the expected long-term increase in output (GDP) caused by an increase in the economy s productive capacity Path of long run output Illustrate the economic cycle Over time the UK economy grows as a result of net investment and improved productivity trend growth. Trend growth measures how fast an economy can grow without inflation - also known as the economy s speed limit In the shorter term, actual GDP moves through an economic cycle, periods above and below the trend (potential) growth path. Real GDP actual output Potential or trend output Economic cycle Phases slump 1 2. expansion or recovery 3. peak or boom 4. recession time The output gap is usually expressed as a percentage of the level of potential output eg 2% Output gaps An output gap is the difference between potential and actual GDP. A positive output gaps occurs when actual GDP is above trend GDP generating inflationary pressure. Negative output gaps mean actual GDP is below trend causing unemployment Is the economic cycle a problem? What is the impact of the economic cycle? Each stage of the economic cycle present challenges to the government s macroeconomic objectives: In the recovery/boom stages demand may exceed supply in various markets causing a) inflation as wages and prices to rise and b) a deterioration in the balance of payments current account as imports rise In the recession/slump stages, supply exceeds demand resulting in a) layoffs & unemployment b) falling government tax revenues & c) increased benefit payments (G>T). However inflationary pressure falls and the current account improves. The impact of the economic cycle will vary by: The length and depth of the recession eg a short six-month recession with a 0.1% fall in GDP has minimal impact. A 10 year depression with output falling by 30% has severe implications for the economy Sector: It is quite possible for manufacturing to be in recession while the service sector is booming Industry: firms producing luxury goods with a high income elasticity of demand are more affected by the economic cycle than firms producing essentials Region: the impact of a recession will be different in the South East with a strong service sector than the midlands north with large manufacturing In 2005 the govt moved the beginning date of the current economic cycle from 1999 to Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 16

11 1.7 Employment & Unemployment What is the working age population? What is the labour force Define unemployment Define the unemployment rate How is unemployment (U) measured? Is the LFS an accurate measure of unemployment? What are the consequences of unemployment Unemployment raises equity issues? Using Labour Force Survey data the working age population (16-64 male female) has two main categories: Economically active, workforce or labour force made up of the employed and job seekers ie unemployed workers actively seeking work Economically inactive are people of working age not in employment or satisfying LFS unemployment criteria through early retirement, looking after family and home, long-term sickness or full-time education. Working age population of 47,727 million is made up of: Economically active ie the labour force 30,080 Source ONS Dec 2005 Employed 28,656 LFS measure of Unemployed (job seekers) 1,424 Economically inactive 17,633 The labour force is the total number of people able available and willing to participate in paid employment ie 1) the employed labour force plus 2) those registered as unemployed and actively looking for new work. Unemployment occurs when individuals are jobless but willing and able to work at the going wage rate. Official government figures only count people who register as unemployed and are actively searching for work. The unemployment rate is the percentage of the labour force are out of work but actively seeking employment ie: unemployment rate = number unemployed/labour force x 100 There are two methods of estimating unemployment: Claimant count only includes those who are unemployed and claiming benefits ie those eligible to claim the Job Seeker's Allowance. This method is quick and inexpensive but understates the true level of unemployment because many people are interested in finding work but do meet all of the criteria for claiming JSA. The International Labour Organisation s Labour Force Survey (LFS) or ILO measure counts only those who have looked for work in the past month and are able to start employment in the next two weeks. The LFS is an internationally used broader, if slower & more expensive, method of measuring unemployment then the claimant count method. Using LFS methodology, only persons actively looking for work are classified as unemployed. This excludes: Discouraged workers who want a job but have given up looking because they have decided the search is hopeless. Diversion from unemployment to sickness. 2.5 million non-employed adults of working age claim sickness related benefits but are not officially classified as unemployed lost output (opportunity cost), External costs eg poverty and diminished social lost government tax revenue and cohesion; loss of status, alienation and frustration. Increased expenditure on unemployment benefits The effects of depend on the rate & duration The unemployed have the lowest incomes. Finding jobs raises incomes and reduces inequality even low paid jobs. Reallocating resources involves people losing and finding a job a painful not costless process. The labour force shows the total number of people able available and willing to participate in paid employment plus those registered as unemployed and actively looking for new work. Also called whole economy labour supply Is unemployment simply people without a job? What about those only willing to accept high paid fulltime jobs? Discouraged workers would like to work but have given up looking for jobs after an unsuccessful search and are not included in official unemployment statistics The longer the average time workers are jobless, the higher the costs of U Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 17

12 1.7.9 State the main categories of unemployment Voluntary & involuntary unemployment is? What is full employment? How can there be unemployment when an economy is at full employment? The natural rate of unemployment is? Zero cyclical unemployment? Outline the Unemployment trap What are UK employment trends? Categories of Unemployment Type Description Cause Remedy Frictional Structural Cyclical or Demand deficient Classical Unemployed temporarily between jobs eg newly redundant worker Mismatch of labour skills of unemployed to job opportunities. Fluctuating unemployment from insufficient AD Unemployment caused by market disequilibrium Normal labour turnover and the resultant delays in applying for interviewing & accepting jobs. Job searches take time. Changed supply & demand from evolving consumer tastes & new technologies and the immobility of labour. Insufficient AD, given potential AS, creates a negative output gap. Linked to economic cycles. Real wages held above their market clearing level causing excess labour supply Improve job information, eg better job centres. Reduce amount & duration of unemployment benefits Offer retaining to improve occupational immobility and relocation grants to improve geographical immobility Manage the economic cycle to reduce or even eliminate output gaps Improve the operation of labour markets eg weaken trade union power Voluntary unemployment: when a worker chooses not to accept a job at the going wage rate but to remain unemployed. This may be the result of the unemployment trap: take home pay from working is less than unemployment benefits. Involuntary unemployment when a worker is willing to accept a job at the going wage but cannot get a job offer. Full employment is the highest possible level of employment and occurs when those seeking work can find jobs at the going wage rate ie there is no cyclical unemployment Full employment does not mean that everyone is employed. Economies are dynamic and respond to changes in consumer taste and new technologies by reallocating resources. Frictions & structural changes mean there is always unemployment Frictions: Businesses take time to advertise & recruit workers. Job seekers need time to find and take up new employment Structural changes: new technologies and competitors create job losses in industries and regions. It takes time to overcome the occupational & geographical immobility of labour through retraining or for workers and relocation grants The natural rate of unemployment is the unemployment rate at the full employment level of national income where there is no cyclical unemployment but inevitable frictionally and structurally unemployed. For Keynesian economists, cyclical unemployment is linked to the economic cycle and only occurs in times of recession. In long run equilibrium where actual and potential GDP are identical there is no cyclical unemployment - only frictional and structural The unemployment trap occurs when workers calculate that lost benefits and extra tax mean they are no better off working than if remain unemployed. Government supply side polices such as Families Working Tax Credit & Sure Start seek to break this trap. Unemployment has fallen since 1993 to circa 3% using the claimant count and 5% using the labour force survey method. Falling unemployment is mainly due to actual real GDP growth outstripping trend GDP; Many workers have given up active job search and left the labour market; the expansion of higher education means fewer job entrants. Listing all the types of unemployment demonstrates low level understanding. Focus on causes implications and cures for the three main types: frictional, structural and cyclical Which policies are most efficient effective and equitable for reducing unemployment? Full employment does not mean zero unemployment: there is frictional & structural but no cyclical (demand deficient) unemployment 3% unemployment indicates full employment in the UK Economics can sound very clinical when discussing unemployment. There is nothing natural about unemployment especially for the unemployed Powell. The demand for labour is a derived demand. Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 18

13 Unemployment spider diagram Involuntary labour want employment at going wage but cannot get a job offer. Voluntary: labour decline job offer at going wage rate lost output (opportunity cost) More unemployment benefits Labour Force Survey Claimant Count Measurement Unemployment Costs lost government tax revenue External costs eg poverty effects depend on the Categories rate & duration of U Frictional workers temporarily between jobs Structural unemployed have the wrong skills in the wrong place Cyclical fluctuating unemployment linked to the business cycle. immobility of labour Involuntary Lack of AD given AS geographical occupational large regional differences in unemployment levels Tutor2u Macroeconomics Q&A 2006 Edition Richard Young Page 19