Macroeconomics. PartC

Transcription

1 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page 231 PartC Macroeconomics 8 Aggregate demand and the national economy Aggregate supply and growth Banking, money and interest rates Inflation and unemployment Macroeconomic policy 381

2 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page 232 CHAPTER MAP 8.1 Introduction to macroeconomics 234 Key macroeconomic issues The circular flow of income model 237 The inner flow, withdrawals and injections 239 The relationship between withdrawals and injections 241 The circular flow of income and the four macroeconomic objectives 242 Disequilibrium and a chain reaction The components of aggregate demand 243 Household consumption 243 Investment 248 Government expenditure 250 Imports and exports The equilibrium level of national income 252 Showing equilibrium with Keynesian diagram 253 The withdrawals and injections approach 253 The income and expenditure approach The multiplier 256 The withdrawals and injections approach 256 The income and expenditure approach 257 The multiplier: a numerical illustration 258 Appendix: Measuring national income and output 259 The product method 259 The income method 260 The expenditure method 262 From GDP to national income 263 Households disposable income 263 Taking account of inflation 264

3 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page chapter Aggregate demand and the national economy We turn now to macroeconomics. This will be the subject for this third part of the book and most of the final part. As we have already seen, microeconomics focuses on individual markets. In macroeconomics we take a much loftier view. We examine the economy as a whole. We still examine demand and supply, but now it is the total level of spending in the economy and the total level of production. In other words, we examine aggregate demand and aggregate supply. In particular, we will be examining four key topics. The first is national output. What determines the size of national output? What causes it to grow? Why do growth rates fluctuate? Why do economies sometimes surge ahead and at other times languish in recession? The second is employment and unemployment. What causes unemployment? If people who are unemployed want jobs, and if consumers want more goods and services, then why does our economy fail to provide a job for everyone who wants one? Then there is the issue of inflation. Why is it that the general level of prices always seems to rise, and only rarely fall? Why is inflation a problem, and would it be a good thing or a bad thing if prices did fall? Why do countries central banks, such as the Bank of England, set targets for the rate of inflation? The final topic, which is the subject of the final part of the book, concerns a country s economic relationships with other countries. We look at international trade and investment and at the flows of foreign currencies around the world. In this chapter, after a preliminary look at the range of macroeconomic issues, we then focus on national output. In doing this we identify the key purchasers of goods and services in the economy and the ways in which these purchasers are connected. We see what determines the level of spending. We go on to develop a simple model of the economy, in which prices are held constant, to consider how national output in any one year is determined. After studying this chapter, you should be able to answer the following questions: What are the key macroeconomic issues faced by all countries? Who are the key groups of purchasers whose demands determine the total level of spending on a country s goods and services? What are the various flows of incomes around the economy? What causes these flows to expand or contract? How do we measure national output? What factors influence the level of spending by firms, households and government? What determines the level of national output at any one time? What is the effect on national income of an increase in spending?

4 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page Chapter 8 Aggregate demand and the national economy 8.1 INTRODUCTION TO MACROECONOMICS What issues does macroeconomics tackle? The first half of the book was concerned with microeconomics. By focusing on individual markets, microeconomics enables us to focus on individual decisions. For instance, we can analyse the decision-making process of firms as they decide on what goods and services to produce and how to produce them. Similarly, we can analyse individuals as they decide how to allocate their budget between different consumption options or what jobs to take. As we saw on the previous page, the issues addressed by macroeconomists relate in one way or another to the total level of spending in the economy (aggregate demand) or the total level of output (aggregate supply). But macroeconomics is still concerned with understanding human behaviour. However, a macroeconomist will typically take a broader perspective than a microeconomist. This may involve analysing groups or sectors within the economy, such as the household or corporate sectors, or the government. It is also worth keeping in mind that macroeconomics is often characterised by quite lively debates. These concern the precise causes of various macroeconomic problems and what policies are best to tackle them. Key macroeconomic issues We now outline four broad issues that are generally of concern to policy-makers. However, the attention given to them will inevitably be affected by the economic circumstances of the time for example, whether the economy is booming or in recession. Definition Rate of economic growth The percentage increase in output between two moments of time, typically over a 12-month period. Economic growth Governments try to achieve high rates of economic growth over the long term: in other words, growth that is sustained over the years and is not just a temporary phenomenon. Governments also try to achieve stable growth, avoiding both recessions and excessive short-term growth that cannot be sustained. In practice, however, this can often prove difficult to achieve. KI 1 p 5 KEY IDEA 28 TC 12 Economies suffer from inherent instability. As a result, economic growth and other macroeconomic indicators tend to fluctuate. This is Threshold Concept 12. It is a threshold concept because it is vital to recognise the fundamental instability in market economies. Analysing the ups and downs of the business cycle occupies many macroeconomists. Figure 8.1 shows how growth rates have fluctuated over the years for four economies. 1 As you can see, in all four cases there has been considerable volatility in their growth rates. 1 Note that EU-12 stands for the 12 original members of the eurozone: Austria, Belgium, Germany, Greece, Finland, France, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain.

5 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page Introduction to macroeconomics 235 Figure 8.1 Growth rates in selected industrial countries 10 8 UK EU-12 USA Japan Annual economic growth rate (%) Notes: 2009 and 2010 based on forecasts; EU-12 = the 12 original members of the eurozone Source: Based on data in Economic Outlook (OECD, various years) Unemployment Reducing unemployment is another major macroeconomic aim of governments, not only for the sake of the unemployed themselves, but also because it represents a waste of human resources and because unemployment benefits are a drain on government revenues. Unemployment in the 1980s and early 1990s was significantly higher than in the 1950s, 1960s and 1970s. Then, in the late 1990s and early 2000s, it fell in some countries, such as the UK and the USA. In others, such as Germany and France, it remained stubbornly high. This is illustrated in Figure 8.2, which shows unemployment rates (as a percentage of the labour force) for the same four economies. You can also see that unemployment has fluctuated over the years with the ups and downs of the respective economies. For example, UK unemployment rose in the recessions of the early 1980s, early 1990s and late 2000s, but fell in the boom of the late 1980s and mid-to-late 1990s. Inflation By inflation we mean a general rise in prices throughout the economy. Government policy here is to keep inflation both low and stable. One of the most important reasons for this is that it will aid the process of economic decision-making. For example, businesses will be able to set prices and wage rates, and make investment decisions with far more confidence. We have become used to low inflation rates and in some countries, like Japan, periods of deflation, with a general fall in prices. But, it was not long ago that inflation rates in most developed countries were in double figures. In 1975, UK inflation reached 24 per cent. Figure 8.3 illustrates annual rates of inflation (annual percentage change in the consumer prices) in the same four economies. In most developed countries, governments have a particular target for the rate of inflation. In the UK the target for the growth of consumer prices is 2 per cent. The Definition Inflation rate (annual) The percentage increase in prices over a 12-month period.

6 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page Chapter 8 Aggregate demand and the national economy Figure 8.2 Unemployment rates in selected industrial economies Unemployment (% of workforce) UK EU-12 USA Japan Notes: 2009 and 2010 based on forecasts; EU-12 = the 12 original members of the eurozone Source: Based on data in Economic Outlook (OECD, various years) Figure 8.3 Inflation rates in selected industrial economies Definition Balance of payments account A record of the country s transactions with the rest of the world. It shows the country s payments to or deposits in other countries (debits) and its receipts or deposits from other countries (credits). It also shows the balance between these debits and credits under various headings. Inflation (% increase in retail prices) UK EU-12 USA Japan Notes: 2009 and 2010 based on forecasts; EU-12 = the 12 original members of the eurozone Source: Based on data in Economic Outlook (OECD, various years) Bank of England then adjusts interest rates to try to keep inflation on target (we see how this works in Chapter 12). The balance of payments A country s balance of payments account records all transactions between the residents of that country and the rest of the world. These transactions enter as

7 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page The circular flow of income model 237 either debit items or credit items. The debit items include all payments to other countries: these include the country s purchases of imports, the spending on investment it makes abroad and the interest and dividends paid to people abroad who have invested in the country. The credit items include all receipts from other countries: from the sales of exports, from inward investment expenditure and from interest and dividends earned from abroad. The sale of exports and any other receipts earn foreign currency. The purchase of imports or any other payments abroad use up foreign currency. If we start to spend more foreign currency than we earn, one of two things must happen. Both are likely to be a problem. The balance of payments will go into deficit. In other words, there will be a shortfall of foreign currencies. The government will therefore have to borrow money from abroad, or draw on its foreign currency reserves to make up the shortfall. This is a problem because, if it goes on too long, overseas debts will mount, along with the interest that must be paid; and/or reserves will begin to run low. The exchange rate will fall. The exchange rate is the rate at which one currency exchanges for another. For example, the exchange rate of the pound into the dollar might be 1 = $1.60. If the government does nothing to correct the balance of payments deficit, then the exchange rate must fall: for example, to $1.55 or $1.50, or lower. (We will show just why this is so in Chapter 12.) A falling exchange rate is a problem because it pushes up the price of imports and may fuel inflation. Also, if the exchange rate fluctuates, this can cause great uncertainty for traders and can damage international trade and economic growth. In order to achieve the goals of high and sustainable economic growth, low unemployment, low inflation, a satisfactory balance of payments and stable exchange rates, the government (or central bank) may seek to control several intermediate variables. These include taxes, government expenditure, interest rates and the supply of money. We will be looking at the relationship between all these in the coming chapters. Definitions Exchange rate The rate at which one national currency exchanges for another. The rate is expressed as the amount of one currency that is necessary to purchase one unit of another currency (e.g. A1.55 = 1). Central bank a country s central bank is banker to the government and the banks as a whole (see Section 10.2). In most countries the central bank operates monetary policy by setting interest rates and influencing the supply of money. The central bank in the UK is the Bank of England; in the eurozone it is the European Central Bank (ECB) and in the USA it is the Federal Reserve Bank (the Fed ). Recap 1. Macroeconomics, like microeconomics, looks at issues such as output, employment and prices; but it looks at them in the context of the whole economy. 2. The four main macroeconomic goals that are generally of most concern to governments are economic growth, reducing unemployment, keeping inflation low and stable, and avoiding balance of payments and exchange rate problems. THE CIRCULAR FLOW OF INCOME MODEL 8.2 How is spending related to income and who are the key groups of purchasers in the economy? KI 27 p 204 Unfortunately, the pursuit of any one of the four objectives that we have identified may make at least one of the others worse. For example, attempts to increase the rate of economic growth by giving tax cuts so as to boost consumer spending, and

8 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page Chapter 8 Aggregate demand and the national economy Figure 8.4 The circular flow of income Definition Aggregate demand (AD) Total spending on goods and services made in the economy. It consists of four elements: consumer spending (C), investment (I), government spending (G) and the expenditure on exports (X), less any expenditure on foreign goods and services (M): AD = C + I + G + X M 2. An alternative way of specifying this is to focus on just the component of each that goes to domestic firms. We use a subscript d to refer to this component (i.e. with the imported component subtracted). Thus AD = C d + I d + G d + X. thereby encourage investment, may lead to higher inflation. It is thus important to understand the relationship between the four objectives. One way in which the objectives are linked is through their relationship with aggregate demand (AD). This is the total spending on goods and services made within the country by four groups of people: consumers on goods and services (C), firms on investment (I ), the government on goods, services and investment (such as education, health and new roads) (G) and people abroad on this country s exports (X). From these four we have to subtract any imports (M) since aggregate demand refers only to spending on domestic firms. Thus: 2 AD = C + I + G + X M To show how the four objectives are related to aggregate demand, we use a simple model of the economy. This is the circular flow of income model and is shown in Figure 8.4. It is an extension of the model we looked at back in the Chapter 1 (see Figure 1.5 on page 15). If we look at the left-hand side of the diagram we can identify two major groups: firms and households. Each group has two roles. Firms are producers of goods and services; they are also the employers of labour and other factors of production. Households (which include all individuals) are the consumers of goods and services; they are also the suppliers of labour and various other factors of production. In the diagram there is an inner flow and various outer flows of incomes between these two groups. TC 3 p 11 2 An alternative way of specifying this is to focus on just the component of each that goes to domestic firms. We use a subscript d to refer to this component (i.e. with the imported component subtracted). Thus AD = C d + I d + G d + X.

9 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page The circular flow of income model 239 Before we look at the various parts of the diagram, a word of warning. Do not confuse money and income. Money is a stock concept. At any given time, there is a certain quantity of money in the economy (e.g. 100 billion). But that does not tell us the level of national income. Income is a flow concept (as is expenditure). It is measured as so much per period of time. KEY IDEA 29 Stocks and flows. A stock is a quantity of something at a given point in time. A flow is an increase or decrease in something over a specified period of time. This is an important distinction and a common cause of confusion. The relationship between money and income depends on how rapidly the money circulates: its velocity of circulation. (We will examine this concept in detail later on.) If there is 100 billion of money in the economy and each 1 on average is paid out as income five times per year, then annual national income will be 500 billion. The inner flow, withdrawals and injections The inner flow Firms pay money to households in the form of wages and salaries, dividends on Definition shares, interest and rent. These payments are in return for the services of the factors of production labour, capital and land that are supplied by households. The consumption of Thus on the left-hand side of the diagram, money flows directly from firms to domestically produced goods and services (C d ) households as factor payments. The direct flow of Households, in turn, pay money to domestic firms when they consume domestically produced goods and services (C d ). This is shown on the right-hand side of households to firms for payments from the inner flow. There is thus a circular flow of payments from firms to households goods and services produced within the to firms and so on. country. If households spend all their incomes on buying domestic goods and services, and if firms pay out all this income they receive as factor payments to domestic households, and if the velocity of circulation does not change, the flow will continue at the same level indefinitely. The money just goes round and round at the same speed and incomes remain unchanged. In the real world, of course, it is not as simple as this. Not Pause for thought all income gets passed on round the inner flow; some is withdrawn. At the same time, incomes are injected into the flow Would this argument still hold if prices rose? from outside. To help understand this we need to recognise that there other groups of purchasers (i.e. demanders). So far we have identified households and firms as two key groups in the economy. If we introduce government into our model we have a third group. While this increases the complexity of our model it makes it more realistic and increases the ways in which the total spending on goods and services on the economy can be affected. A fourth group in our economic model is overseas purchasers. This group comprises the foreign equivalents of our three domestic groupings. For instance, it includes French households and Japanese car manufacturers. The final group in the model is financial institutions, such as banks and building societies and they play a key role. They are of course firms, though governments can take stakes in them or even own them outright. Financial institutions act as the link between those who wish to borrow and those who wish to save. In this way,

10 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page Chapter 8 Aggregate demand and the national economy for instance, financial institutions can provide firms with the access to the credit they need to fund investment projects, such as the purchase of new machinery. Let us now incorporate our additional purchasers and the financial system into our model. We begin by focusing on the withdrawals from and injections into the inner flow. Withdrawals (W) Definitions Withdrawals (W) (or leakages) Incomes of households or firms that are not passed on round the inner flow. Withdrawals equal net saving (S) plus net taxes (T) plus import expenditure (M): W = S + T + M. Transfer payments Moneys transferred from one person or group to another (e.g. from the government to individuals) without production taking place. Only part of the incomes received by households will be spent on the goods and services of domestic firms. The remainder will be withdrawn from the inner flow. Likewise only part of the incomes generated by firms will be paid to UK households. The remainder of this will also be withdrawn. There are three forms of withdrawals (or leakages as they are sometimes called). Net saving (S). Saving is income that households choose not to spend but to put aside for the future. Savings are normally deposited in financial institutions such as banks and building societies. This is shown in the bottom right of Figure 8.4. Money flows from households to banks, etc. What we are seeking to measure here, however, is the net flow from households to the banking sector. We therefore have to subtract from saving any borrowing or drawing on past savings by households to arrive at the net saving flow. Of course, if household borrowing exceeded saving, the net flow would be in the other direction: it would be negative. Net taxes (T). When people pay taxes (to either central or local government), this represents a withdrawal of money from the inner flow in much the same way as saving: only in this case, people have no choice. Some taxes, such as income tax and employees national insurance contributions, are paid out of household incomes. Others, such as VAT and excise duties, are paid out of consumer expenditure. Others, such as corporation tax, are paid out of firms incomes before being received by households as dividends on shares. (For simplicity, however, taxes are shown in Figure 8.4 as leaving the circular flow at just one point. It does not affect the argument.) When, however, people receive benefits from the government, such as unemployment benefits, child benefit and pensions, the money flows the other way. Benefits are thus equivalent to a negative tax. These benefits are known as transfer payments. They transfer money from one group of people (taxpayers) to others (the recipients). In the model, net taxes (T ) represents the net flow to the government from households and firms. It consists of total taxes minus benefits. Import expenditure ( M). Not all household consumption (C) is of totally homeproduced goods (C d ). Households spend some of their incomes on imported goods and services, or on goods and services using imported components. Although the money that consumers spend on such goods initially flows to domestic retailers, it will eventually find its way abroad, either when the retailers or wholesalers themselves import them, or when domestic manufacturers purchase imported inputs to make their products. This expenditure on imports constitutes the third withdrawal from the inner flow. This money flows abroad. As we shall see, households are not the only group to purchase imported goods and services or goods and services using imported components: firms and government do too. These expenditures also contribute towards the sum of import expenditures (M) and affect the level of aggregate demand.

11 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page The circular flow of income model 241 Total withdrawals are simply the sum of net saving, net taxes and the expenditure on imports: W = S + T + M Injections (J) Only part of the demand for firms output arises from consumers expenditure. The remainder comes from other sources outside the inner flow. These additional components of aggregate demand are known as injections (J). There are three types of injection. Investment on domestically produced goods (I d ). This is firms spending on domestically produced goods and services after obtaining the money from various financial institutions either past savings or loans, or through a new issue of shares. They may invest in plant and equipment or may simply spend the money on building up stocks of inputs, semi-finished or finished goods. Not all of the investment expenditure (I ) undertaken by domestic firms is on totally home-produced goods. Investment expenditure on goods and services produced overseas contributes towards import expenditure (M ). Definition Injections (J ) Expenditure on the production of domestic firms coming from outside the inner flow of the circular flow of income. Injections equal investment (I d ) plus government expenditure (G d ) plus expenditure on exports (X). Government expenditure on domestically produced goods and services (G d ). When the government (both central and local) spends money on goods and services produced by domestic firms, this counts as an injection. (Note that government expenditure in this model does not include state benefits. These transfer payments, as we saw above, are the equivalent of negative taxes and have the effect of reducing the T component of withdrawals.) As well as providing goods and services by purchasing from firms, governments can actually own and run operations themselves. In these cases, the wages of public-sector staff will also be a component of the government s expenditure and are a flow of factor payments to households. As with investment, not all government purchases (G) are on totally homeproduced goods and services. Expenditures on items made overseas contribute towards import expenditure (M ). Export expenditure (X). Money flows into the circular flow from abroad when households, firms and governments abroad buy our exports of goods and services. Total injections are simply the sum of investment and government expenditure (both only domestic products) and exports: J = I d + G d + X Aggregate demand, as we have seen, is the total spending on domestic firms. In other words it is the spending by the household sector on domestically produced goods and services (C d ), plus the three injections: AD = C d + J The relationship between withdrawals and injections There are indirect links between saving and investment via financial institutions, between taxation and government expenditure via the government (central and local), and between imports and exports via foreign countries. These links, however, do not guarantee that S = I d or G d = T or M = X.

12 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page Chapter 8 Aggregate demand and the national economy Take investment and saving. The point here is that the decisions to save and invest are made by different people, and thus they plan to save and invest different amounts. Likewise the demand for imports may not equal the demand for exports. As far as the government is concerned, it may choose not to spend all its tax revenues: to run a budget surplus ; or it may choose to spend more than it receives in taxes: to run a budget deficit by borrowing to make up the difference. Thus planned injections (J ) may not equal planned withdrawals (W ). The circular flow of income and the four macroeconomic objectives If planned injections are not equal to planned withdrawals, what will be the consequences? If injections exceed withdrawals, the level of expenditure will rise: there will be a rise in aggregate demand. This extra spending will increase firms sales and thus encourage them to produce more. Total output in the economy will rise. Thus firms will pay out more in wages, salaries, profits, rent and interest. In other words, national income will rise. The rise in aggregate demand will have the following effects upon the four macroeconomic objectives: KI 27 p 204 Pause for thought What will be the effect on each of the four objectives if planned injections are less than planned withdrawals? There will be economic growth. The greater the initial excess of injections over withdrawals, the bigger will be the rise in national income. Unemployment will fall as firms take on more workers to meet the extra demand for output. Inflation will tend to rise. The greater the rise in aggregate demand relative to the capacity of firms to produce, the more will firms find it difficult to meet the extra demand, and the more likely they will be to raise prices. The exports and imports part of the balance of payments will tend to deteriorate. The higher demand sucks more imports into the country, and higher domestic inflation makes exports less competitive and imports relatively cheaper compared with home-produced goods. Thus imports will tend to rise and exports will tend to fall. Disequilibrium and a chain reaction When injections do not equal withdrawals, a state of disequilibrium will exist: aggregate demand will rise or fall. Disequilibrium results in a chain reaction so as to bring the economy back to a state of equilibrium where injections are equal to withdrawals. To illustrate this chain reaction, let us consider the situation again where injections exceed withdrawals. Perhaps there has been a rise in business confidence so that investment has risen. Or perhaps there has been a tax cut so that withdrawals have fallen. As we have seen, the excess of injections over withdrawals will lead to a rise in national income. But as national income rises, so households will not only spend more on domestic goods (C d ), but also save more (S), pay more taxes (T ) and buy more imports (M ). In other words, withdrawals will rise. This will continue until they have risen to equal injections. At that point, national income will stop rising, and so will withdrawals. Equilibrium has been reached. TC 5 p 40 In Section 8.5 we return to the circular flow model to address in more detail how changes in aggregate demand can affect the level of national income. In other words, we will consider the chain reaction resulting from disequilibrium and its impact on an economy s size. But, now we consider in more detail the significance in money terms of our purchasers of goods and services that we identified in the model.

13 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page The components of aggregate demand 243 Recap 1. The circular flow of income model depicts the flows of money round the economy. The inner flow shows the direct flows between firms and households. Money flows from firms to households in the form of factor payments, and back again as consumer expenditure on domestically produced goods and services. 2. Not all incomes get passed on directly round the inner flow. Some is withdrawn in the form of net saving, some is paid in net taxes, and some goes abroad as expenditure on imports. 3. Likewise not all expenditure on domestic firms is by domestic consumers. Some is injected from outside the inner flow in the form of investment expenditure, government expenditure and expenditure on the country s exports. 4. The circular flow will be in equilibrium when planned injections equals planned withdrawals. But, planned injections and withdrawals are unlikely to be the equal. This will result in a chain reaction that returns the economy to a position of equilibrium. THE COMPONENTS OF AGGREGATE DEMAND 8.3 What are the main groups that spend money in the economy? We have seen how the demand for the goods and services produced within a nation s borders originate from four broad groups of purchasers: its households, its firms, its government and the foreign equivalents of these across the world. AD = C + I + G + X M The circular flow model demonstrates the interdependence of these groups as well as the significance of the financial system. Changes in the behaviour of these purchasers and of financial institutions can have significant effects on the economy. In this section we consider some of the possible influences on the expenditures by the purchasers of goods and services in order to develop an understanding of what drives changes in the level of aggregate demand. We then use our findings to inform and construct a demand-driven model of the economy in Section 8.5. The magnitude of the components of aggregate demand Before we look in detail at each of the components of aggregate demand, it is worth noting that their magnitude varies from country to country. Table 8.1 presents the average percentage composition of aggregate demand for a selection of developed countries over the period 2000 to The first three columns show the expenditure shares of GDP for purchases made by a country s residents households, firms and government. Of these three components we can see that for each country Pause for thought the largest is the expenditure share on final goods by households (which include non-profit institutions, such as clubs and 1. What are the implications for economic growth rates of the figures for gross capital societies). Typically, household spending accounts for at least expenditure (public and private)? half of the total spending on a country s goods and services and 2. Why are the figures for exports and imports in some cases, such as the UK and the US, considerably more. so high for Singapore and relatively high These figures help to explain why economic activity can be affected by changes in household spending and why it is import- relatively low for Japan? for Ireland and so low for the USA and ant to consider what factors may affect household spending. Household consumption As we can see in Table 8.1, the largest component of aggregate demand is household consumption. Therefore, in trying to understand the determination of a nation s

14 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page Chapter 8 Aggregate demand and the national economy Table 8.1 Composition of GDP by type of expenditure, % (average ) Gross capital Government External Household final expenditure final balance consumption (public and private) consumption Imports Exports (X M) Australia France Germany Ireland Japan Singapore Sweden UK USA Source: United Nations output and its changes from period to period a good starting point is to consider what might affect the volume of purchases by households. Disposable income. Perhaps the first determinant you think of as capable of explaining consumption is disposable income. Disposable income is the income that the household sector has available for spending or saving after deductions, such as income tax and payments to social insurance schemes, and any additions, such as social benefits. Evidence suggests that, over the long run, when people s disposable income rises, they will spend most of it. So if your disposable income rises from at the age of 25 to at the age of 35, you will spend most of this extra However, short-run changes in disposable income, such as those from one quarter of a year to the next, are relatively more variable than those in spending. For example, many people s income varies with the time of year. Examples include those working in the holiday industry or painting and decorating. However, such people are likely to spread their spending relatively evenly over the year. Case Study 8.1 in MyEconLab looks at the evidence on how consumption varies with disposable income in both the short and long run. Definitions Disposable income Income after tax and other deductions and after the receipt of benefits. Consumption smoothing The act by households of smoothing their levels of consumption over time despite facing volatile incomes. Debt-servicing costs The costs incurred when repaying debt, including debt interest payments. Expected future incomes. Many people take into account both current and expected future incomes when planning their current and future consumption. You might have a relatively low income when you graduate, but can expect (you hope!) to earn much more in the future. You are thus willing to take on more debts now in order to support your consumption, not only as a student but shortly afterwards as well, anticipating that you will be able to pay back these loans later. It is similar with people taking out a mortgage to buy a house. They might struggle to pay the interest at first, but hope that this will become easier over time. In fact, the financial system (such as banks and building societies) plays an important part in facilitating this smoothing of consumption by households. You can borrow when your income is low and pay back the loans later on when your income is higher. The financial system and consumption. The financial sector can have a major impact on the household sector s spending. For example, if interest rates rise, loans become more expensive for households to service. Debt-servicing costs are the costs TC 9 p 71

15 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page The components of aggregate demand 245 incurred in repaying the loans and the interest payments on the loan. Where the rate of interest rate on debt is variable any changes in interest rates affect the cost of servicing the debt. Interest rate changes may also affect saving. For example, a rise in interest rates will increase the return on savings, giving households the incentive to substitute future consumption through saving in place of current consumption. Therefore, there is a substitution effect to increase saving and reduce consumption. But, in order for households to obtain a given amount of interest income they actually need to save less since interest rates are higher and so there is an income effect to save less and spend more. Financial institutions can affect the strength of consumption if their ability and willingness to provide credit changes. The global financial crises of the second half of the 2000s saw credit criteria tighten dramatically. A tightening of credit practices, such as reducing overdraft facilities or reducing income multiples (the size of loans made available relative to household incomes), weakens consumption growth. In contrast, a relaxation of lending practices, as seen in many countries during the 1980s, can strengthen consumption growth. Pause for thought In recent years there has been an increase in the use of individual voluntary arrangements (IVAs) whereby households who have got into financial trouble try to arrange a repayment schedule with their creditors. These arrangements often involve some of the debt being written off. What is the effect likely to be on borrowing? KI 29 p 239 Household balance sheets By borrowing and saving households accumulate financial liabilities (debts), financial assets (savings) and physical assets (property). Table 8.2 shows a summary balance sheet of the net worth of the UK household sector. The net worth of the household sector is the sum of the sector s net financial wealth and its physical wealth. Net financial wealth is the balance of financial assets over financial liabilities. Financial assets include moneys in savings accounts, shares and pension funds. Financial liabilities include debts secured against property, largely residential mortgages, and unsecured debts, such as overdrafts and unpaid balances on credit cards. Physical wealth is predominantly the sector s residential housing wealth and is, therefore, affected by changes in house prices. Policy-makers, including central bankers, will analyse the net worth of the household sector and the composition of its balance sheets. The sector s financial health or level of financial distress can have a significant impact on short-term prospects for household spending. For instance, a declining net worth to income ratio, could indicate greater financial distress. This could be induced by falling Table 8.2 Summary of household balance sheets, 31 December 2008 billion Ratio to disposable income Financial assets Financial liabilities Net financial wealth Physical wealth Net worth Source: United Kingdom National Accounts: The Blue Book (National Statistics, 2009) Note: Figures include assets and liabilities of the NPISH (non-profit institutions serving households) sector

16 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page Chapter 8 Aggregate demand and the national economy BOX 8.1 THE EXPLOSION OF DEBT Did it affect household spending? Many of us at some time or other will have experience of debt. As a student, you are probably experiencing it right now! We can categorise debt as either secured or unsecured ; secured debt is debt where property acts as collateral which, if necessary, could be sold to pay off some or all of the debt. As the table shows, households in the UK in 2008 had amassed a staggering 1.6 trillion of debt, of which 75 per cent was secured debt. Twenty years earlier the stock of debt was 311 billion, of which secured debt was 70 per cent. One way of trying to put the size of household debt into context is to compare it with the sector s annual disposable income. This reveals that from being equivalent to just a little over a year s worth of disposable income in 1988, the total amount of debt had risen to 1.75 times annual income by But, does this increase in debt have implications for household spending? For instance, does it affect the stability of household spending? If households were making careful choices to take on more debt now, planning to be able to pay them off later when their incomes were higher, then perhaps we should not be too worried. But, how realistic is this? By far the largest financial liability of the household sector is secured debt. Between 1970 and 2008 secured debt increased from 10.5 billion to 1.18 trillion equivalent to an increase each year of some 13 per cent. Chart (a) shows the amount of secured debt as both percentages of annual GDP and household-sector disposable income in the UK since Both measures show an increase in the scale of debt during the 1980s and again from the mid-1990s through to the financial crisis of , when the level of secured debt to both GDP and income reached historic highs. Debt held by UK Household Sector: September 1988 and 2008 September 1988 September 2008 % of annual % of annual % of disposable % of disposable billions liabilities income billions liabilities income Financial liabilities Secured debt Non-secured debt Source: Based on data in UK Economic Accounts (National Statistics) Note: Figures relate to both the household and NPISH (Non-Profit Institutions Serving Households) sectors. The NPISH sector comprises charities and voluntary organisations. (a) Secured debt as a percentage of GDP and disposable income % of GDP % of disposable income Percentage

17 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page The components of aggregate demand 247 CASE STUDIES & APPLICATIONS (b) Housing equity withdrawal and consumption as percentages of annual disposable income Consumption HEW 10 8 Consumption HEW So should we be concerned by the rise in the exposure to secured debt? Unlike unsecured debt, this debt is secured against property. Its increase reflects the growth in owner-occupation (the number of owner-occupiers in the UK increased from 9.6 to 18.6 million between 1971 and 2007) and the rise in the average price of housing by nearly 10 per cent per annum (see Box 2.2 on pages 42 3). Therefore, while the sector has been accumulating debt it has also been accumulating housing wealth. In other words, a large part of the increase in debt in the UK is explained by the purchase of residential housing. But house prices are volatile. This, combined with the sheer scale of secured debt, creates the potential for significant short-term effects on household spending. When house prices are rising households may increase spending by borrowing additional sums from mortgage lenders. This is known as housing equity withdrawal (HEW). When house prices fall, people may attempt to pay off more of their mortgage for fear of getting into negative equity (owing more than the value of the house). To do this they have to cut back on consumption. Chart (b) shows both the amounts of HEW and consumption as percentages of disposable income. Interestingly, they track each other very closely in the late 1980s, when rising HEW coincides with a rising propensity of households to consume out of income, and in the early 1990s when an injection of housing equity (negative HEW) coincides with a declining average propensity to consume. The correlation is less clear during the bulk of the 2000s, however. It may be that for a large part of the decade households were extracting housing equity, on the back of strong house price growth, to repay unsecured debt. Later in the decade, as house prices fell, households were injecting housing equity. This coincided with a declining propensity to spend out of income during uncertain times. The stock of debt amassed by households may also lead to changes in spending because of what are known as cash flow effects. For mortgage payers on variable interest rate mortgages, and most are, a rise in interest rates can mean substantial rises in monthly payments. This may force them to cut back on consumption. The impact across the household sector will be larger the higher the proportion of housing debt to national income.? 1. Make a list of the ways in which the debt position of households could lead to changes in their spending. 2. In the late 2000s, the household sector faced declining levels of real disposable income. In what ways could their ability to use the financial system to smooth their spending have been affected in this period? Note: An extended version of this box can be found in the web appendix to this chapter (Web Appendix 8.2). KI 29 p 239

18 M08_SLOM2410_05_SE_C08.QXD 11/13/09 11:28 AM Page Chapter 8 Aggregate demand and the national economy house prices or falling share prices. In response to this we might see the sector engage in precautionary saving or repaying some of its outstanding debt. Therefore, the impact of worsening balance sheets is to weaken spending while improvements on the balance sheets enable consumption to strengthen. Investment There are five major determinants of investment. Increased consumer demand. Investment is to provide extra capacity. This will only be necessary, therefore, if consumer demand increases. The bigger the increase in consumer demand, the more investment will be needed. You might think that, since consumer demand depends on the level of national income, investment must too. But we are not saying that investment depends on the level of consumer demand; rather it depends on how much it has risen. If income and consumer demand are high but constant, there will be no point in firms expanding their capacity: no point in investing. The relationship between investment and increased consumer demand is examined by the accelerator theory. We will look at this theory in Section 9.4. Expectations. Since investment is made in order to produce output for the future, investment must depend on firms expectations about future market conditions. But, TC 9 p 71 BOX 8.2 SURVEYS OF CONFIDENCE What can policy-makers learn from their results? How many times a time each day does somebody ask you how you are feeling? But, what would such a question mean in the context of a country? Well, once a month consumers and firms across the European Union are asked a series of questions, the answers to which are used to compile indicators of consumer and business confidence. For instance, consumers are asked about how they think their household finances will change over the next 12 months. They are offered various options such as get a lot better or get a lot worse and balances are then calculated on the basis of positive and negative replies. a The European Union publishes its confidence indicators for each member country as well as averages for the whole EU. A summary indicator of confidence known as the Economic Sentiment Index attempts to measure the confidence of both consumers and firms. But, why measure confidence? Does confidence perhaps affect the current, or maybe future, levels of aggregate demand? For instance, does low confidence amongst consumers affect their current or future spending plans or does low confidence amongst businesses affect their current for future investment plans? Or does confidence simply reflect the prevailing economic circumstances? In other words, perhaps confidence does a More information on the EU programme of business and consumer surveys can be found at economy_finance/db_indicators/db_indicators8650_en.htm. not contribute to our understanding of demand changes, because it simply reflects other economic variables. The chart plots the Economic Sentiment Index and the annual percentage change in real GDP across all EU countries for years from The chart appears to show that sentiment is a coincident indicator of GDP growth; in other words we could use the path of the Economic Sentiment Index to track the path of GDP growth. Indeed, economic sentiment tracks output growth well throughout most of the period. Sentiment was high in the booms of the late 1990s and mid-2000s. Similarly, economic sentiment tracks the economic downturns of the early 1990s, early 2000s and late 2000s well too. However, there is no clear evidence that this measure of confidence leads actual output growth. The evidence here points to measures of sentiment tracking rather than leading changes in output. This, however, does not mean that changes in sentiment do not cause changes in output. In fact, a likely scenario is that growth and sentiment interact. High growth leads to high confidence (high ESI), which in turn leads to more consumption and investment and hence higher growth, which in turn leads to higher confidence. The reverse is the case in a recession: low growth leads to lack of confidence (low ESI), which causes low or negative growth. Measures of confidence are highly useful because they are published monthly. In contrast, measures of GDP are published annually or quarterly and with a considerable