The Trend of Economic Growth in the UK Economy - Essay Example

and Section # of Q1) Since 1976 we see a fluctuating trend of Economic Growth in the UK’s economy. It can be analyzed by figure 1 from the case that there have been three stages where economic growth has fallen considerably which can be classified into periods of recession. These periods include the early 1980’s recession where the level of GDP fell from peak to trough by 5.9 %, then in early 1990’s where the level of GDP fell from 1990 to 1991 to around 4.5 % which was just a moderate fall however the most severe fall in GDP occurred between 2008 and 2009 that was of 6.3 % which was associated with the global financial crises. The level of GDP increased from trough to peak by around 10.2 percent between the year 1981 and 1988, which states that the recovery was strong after the recession. Also after the 1990’s recession there was a sharp increase in GDP growth level. However it is evident that there is a long recovery period after the 2008 global financial crises of UK’s economy. When compared the recovery from all recession periods, it is evident from Figure 2 from the case that recovery from 2008 recession has been protracted and has the deepest fall in GDP growth levels in the year of 2008 recession. The period of Great Moderation that lasted from 1993 to 2007 was faced with smooth growth, low unemployment and low inflation. During this period economy grew to around 5 percent until it was faced with recession in 2008. Q2) There are a number of factors that can be attributed to a fall in UK’s saving ratio between 1993 and 2008.It is visible from figure 15 from the case that saving ratio fell to lowest 1.7 percent by the end of 2007.The graph also denotes fall in saving ratio over the years 1993 to 2008. Interest rate in the UK’s economy was low from 1993 that further fell to 3 % in 2003 as seen from figure 12 from the case. This meant that credit was easily available to borrowers at a cheaper cost and savers were not ready to delay consumption and instead save for lower return on savings. Low interest rates and low inflation acted as a disincentive to save. At same time housing prices were rising, which leads to wealth affect and people were ready to borrow and spend more. This wealth effect made people more confident to spend as they knew that value of their property was rising. This is could be seen in figure 13 where there is a sharp rise in average UK housing prices from 1993 to 2007, more than tripling over the 15 year period (Tejvan, 2008). Easily available credit during this period had encouraged more consumption i.e. consumption by households and investment by firms had increased contributing to increase in GDP. This was due to that fact that Central banks monetary policy had made interest rates low in order to encourage lending of funds. Consumption had increased in order to have a better standard of living as consumer confidence in spending is boosted. Q3) The term business investment refers to setting up of funds in a business either initially or either by investing by buying out its stocks from the market. So investment is an injection into circular flow of income that could help to increase Aggregate demand and hence the level of GDP in an economy. The current weak situation of Business investment is due to collapse of financial markets after 2008 which made it difficult for firms to borrow money to invest or even raise finance. As banks went out of funds because of their high leverage and are on brink of collapse. Moreover also a recession in the economy and even in Europe that pulled down aggregate demand; hence curtailing business investment. Government could encourage investment in a number of ways, firstly restoring the financial markets so that it becomes easier for firms to borrow money and invest in business resources (Rachel, 2012). Low interest rates would make cost of borrowing easier for firms. Moreover, it will encourage capital allowance on business machinery, van and other items that could be deducted from corporate or income taxes. This would help business to have more cash flow and incentive to invest more. Also by improving the taxation system, Government could reduce the level of taxes to encourage investment and follow Research and development tax scheme. This scheme allows investors who are liable to corporate taxes to get a relief from taxes. Tax reliefs, lower taxes, easy and cheaper access to finance, corporate allowance will then provide an incentive for business investors to invest and boost up the GDP of the economy. Another important is by providing subsidies’ to firms in order to cut down their cost of production. Business investment is very important for a country like UK where it has been low as compared to other European countries. (Rachel, 2012) Q4) Fiscal policy refers to the level of government expenditure and its taxation policy in the economy. Fiscal policy can either be expansionary or it can be contractionary. The type of fiscal policy to use depends on the aim of the government, as it directly affects the level of GDP in the economy. When a government uses an expansionary fiscal policy, as stated by the formula AD = C+I+G+(X-M) which when increases, it increases the level of GDP and hence aggregate demand. To increase GDP, the government will have to follow expansionary fiscal policy that involves cutting taxes and increasing government spending. An increase in aggregate demand will increase the level of real GDP as long as there is spare capacity in the economy.(Sue, Grant 2002) 1 This figure shows an increase in GDP of the economy where Ad rises from AD to AD2, relating to increase in GDP from Y1 to Y2. However expansionary fiscal policy can cause only inflation if the economy is running at full employment level, so in order to increase GDP it is important for the economy to be running at a spare capacity. Also it depends on the confidence of the economy, for expansionary policy to be effective, it is necessary that business confidence is restored and people are willing to take up investment process.(Grant, 2002) Consumer expenditure, business investment should rise along with government expenditure. As increase in government expenditure also requires high government borrowing, it should be made sure that the country is not in too much debt already. Also it requires time for the aggregate demand to increase as it will take time for changes in expenditure to be reflected in increase in GDP as time lags are involved.(Tejvan, 2011) It is said that Economic growth from fiscal policy tends to be short term, so it is important for the economy to have long term sustainable growth that is achieved by using supply side policies that impact LRAS of the economy. (Geoff, 2012) Q5) UK’s economy has been in consistent current account deficit which means that its trade in goods and services in addition to its net income associated with ownership of its foreign assets is negative. Consistent deficit means that UK is spending more than its output, so it is meeting its high demand by importing from other countries that is leading to negative balance of trade. It also shows that UK’s made products are in competitive in International markets. This may also mean that high proportion of UK’s asset is owned by foreigners, hence profits are sent back (Tejvan, 2013). This deficit means that UK is relying on debt from other countries and increasing its debt. It is evident from figure 16 from the case where UK’s current account has been in deficit since 1998.It also means that UK’s products are not competitive in International markets hence demand for exports is low and it may also be true that domestic producers are unable to meet domestic demand, hence this made import bill to rise and also lead to increase in marginal propensity to import. Government can react to this buy a number of ways firstly it needs to discourage import of goods from international markets at the same time make its exports more competitive. They need to make sure that domestic goods are able to fulfill available demand so that there is no need for goods to be imported, at same time persuade UK citizens to buy domestic made goods. Another way is by devaluation of its exchange rate that would make UK’s goods cheaper as compared to other countries and imported goods expensive. UK’s government has followed this policy as it is evident from figure 18 where sterling was devalued in 2008 in order to correct balance of trade.(Inman,2013) Q6) Quantitative easing came into being after the global financial crisis of 2008 that had doomed many economies into recession including of United Kingdom. This was a policy used by UK government in order to provide a solution to recession in the economy, given the interest rates were already low at 0.5 % and this policy only seemed the way out. It is a tool of monetary policy that aims to adjust the circulation of money in the economy by purchasing assets. This is usually done by the central bank of the country that purchases government bonds and other assets from commercial banks, insurance companies, pension funds and other commercial institutions in order to increase money supply in the economy. This helps in increasing the liquidity of banks and making it possible for them to lend easily. It is evident from the passage that Bank of England has put up £375 billion into asset purchases. This policy did help to reduce cost of borrowing, and helped to flow credit in the economy to encourage spending and stimulate the economy. This policy also aims to reduce interest rate. This happens when government buys bonds, market price of bond rises, leading to reduction in long term interest rates in the economy. Hence this lower interest then this encourages more economic activity as cost of borrowing falls. (Tejvan, 2013) As this policy leads to more inflow on money into the economy, given the Fisher Equation where MV= PY an increase in money supply will lead to an increase in inflation in the economy. If we look into this policy it is to note that in short run it will help to provide a kick start to the economy but in long term can lead to inflation. So it is important to make sure that it must be used very carefully by the central bank in a way that its possible harmful effects are minimized. (Tejvan, 2012) Q7) There are various reasons that lead to fall in aggregate demand in UK in 2008 and 2009.One of the major reason was due to Credit Crunch that was shortage of finance i.e. less loans for lending which meant that there was a decline in loans available. The credit crunch led to mortgage lending becoming strict and expensive and moreover it became difficult for banks themselves to borrow money in order to maintain liquidity. This lead to difficult and expensive to borrow loans for business investment and hence investment by firms fell. However Many banks in UK were continuing with huge losses and this lead to them facing the first bank run in 150 years. The banks were holding up funds in order to restore their financial statements and prepare for regulatory changes. At same time house prices and stock prices were falling which lead to negative wealth effect; people had to curtail their consumptions which meant that consumer expenditure part of aggregate demand fell. At same time new house constructing fell considerably which lead fall in investments It is to note that AD= C+I+G+(X-M), where Consumer expenditure, Investments and net exports were falling, pulling down Aggregate demand.(Robert,2008) UK’s economy was also being faced by consecutive current account deficit which meant net exports were also falling. 2 This figure shows a fall in Aggregate demand that is contracting the level of GDP as Ad shifts from AD1 TO AD 2.At same time price level was falls from P1 to P2. Q8) When we compare increase in unemployment rate after 2008 recession as compared to other two periods of recession in UK, we find that the rate of unemployment has been low. This is evident from Figure 4 that shows the rate of unemployment moving above 10 percent both after 1980 recession and early 1990’s.However rate of unemployment has been around 5 percent after 2008. After 2008, UK’s policy makers have tried to recover from recession by making sources of finance available by keeping interest rates low and using quantitative easing. This has encouraged firms to keep their labor until demand resets and workers have also tried to preserve their jobs by accepting wage freezes and even wage cuts. Also Figure 5 shows that the number of people employed increased between 2008 and 2012 by 40000 which meant 576,000 in full-time employment and an increase in 616,000 in part-time jobs. This lead to underemployment as people is not working the hours as they want to. When we see figure 6 we denote that unemployment in youth, those between ages of 16-34 has increased; the highest figure relating to 16-17 age groups where unemployment has been 34.5 percent. It is important to tackle youth unemployment and this could be primarily done by promoting growth of business investment so that more jobs are created. Youth labor should be trained and educated in related to current demand for skills in the economy so that their skills could be matched with the jobs requirements.(Tejvan,2011) Long term sustainable growth is a key factor in creating job opportunities. So the government should promote those sectors that take labor intensive production. Another measure is to devise such policies that allow private employers incentives to employ youth for example subsidies, tax rebates, youth wage rates etc. Q9) The Great Moderation is considered to be a period of 1993-2007 in UK that consisted of low inflation, smooth growth and low unemployment. Over the years UK’s government had to hold back with growth given the rising inflation rate that was to be controlled and that was done by increasing interest rates. Average wage growth in this period was above CPI inflation causing steady growth rate. (Tejvan, 2013) However the period of Great moderation showed growth in output and at same time inflation was low. The central bank was able to keep inflation low without compromising on growth and unemployment level. In this period theory of Phillips curve seemed invalid that shows an inverse relationship between rate of unemployment and inflation.(Tejvan 2013) Low inflation was success of the policy of Central Banks that had aimed for inflation to be low that stayed at around 2 percent. At same time economic growth was achieved that was as a result of loose monetary policy as it made interest rates low, that made financing cheaper. Apart from that there was also a fall in global prices of energy, commodities that helped to maintain low rate of inflation. At same time there was current account deficit as cheaper goods were imported from countries that helped to keep prices low. Although CPI inflation was low but house prices were rising rapidly, this meant that they could drop anytime in future. In this time Banks were highly geared and this was because of excessive borrowing in order to create more profits. This boosted the financial sector and growth in lending provided funds for investment. At same there was greater risk taken during this period as the markets for derivatives came into being after financial deregulation had occurred. This lead way to growth of most common financial derivative credit default swaps. Q10) Economic growth in definition refers to increase in production potential of the economy i.e. more goods and services are produced in a given year, increase in real GDP. The long run growth will depend on growth of productive capacity in the economy that will lead to changes in Long run aggregate supply. For this purpose government could use supply side policies in order to increase LRAS of the economy. An increase in LRAS leads to an increase in production potential of the economy i.e. a shift of production potential to right. Supple side policies tend to be long term as they require structural changes to be made in the economy (Grant,2003). 3 As this figure shows an extension of production potential curve to the right; increasing the production of both capital and Consumer goods. Firstly by reducing taxes in order to encourage more production and at same time reducing welfare benefits, this will increase return from working and reduce return from not working. Government needs to intervene in the labor market by providing training and education to workforce so that labor becomes more productive, flexible and mobile. An increase in an economy’s working population would mean that more labor is willing to produce greater goods and services. This increase in workforce could be by natural rate that is more births than deaths. As same time employment of new production methods such as kaizen, team building, division of labor that helps to achieve efficiency, growth and time saving. Growth of potential output can also occur by increase in resources such as land, labor and capital. By searching new deposits of raw materials, reliable sources of them could be found for the production process for example discovery of oil, gas deposits. Also an improvement in technology can help to achieve an increase in productivity as work process will become more efficient, faster and cheaper. Another way is by government interventions in the markets and encouraging privatization. This provides an incentive for firms to produce more and efficiently as they keep in mind profit motive. This increased efficiency can increase long run growth. 4 This diagram shows an increase in LRAS from LRAS1 TO LRAS2,thus showing an increase in GDP from Y1 to Y2. BIBLIOGRAPHY Books Lipsey,Richard G,(2004) Economics tenth edition. 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