Download UNIT 9 : Economics

UNIT 9 : Economics
Macroeconomic problems
This unit should enable you to understand and explain
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The effects of inflation
Types of unemployment
The effects of unemployment
The determinants of economic growth
The problems associated with economic growth
Macroeconomics deals with the economy as a whole. When there are problems that
affect the whole economy, not just individual markets, then these can rightly be called
macroeconomic problems.
In this unit we will look at three major macroeconomic issues that concern the citizens
and governments of every country and examine the key factors underlying those
issues. Policies aimed at dealing with these problems will be dealt with in unit 10.
MACROECONOMIC PROBLEMS
INFLATION
We have seen what inflation is and how it is measured in unit 8 but we haven’t yet
considered, in detail, why it is a problem. We will do this now.
1.
‘Menu costs’
When prices change frequently there are implications for many firms and individuals.
Price lists have to be changed, catalogues re-printed, and signs changed. Vending
machines, parking meters and all other devices that operate with cash will have to be
adjusted to cope with rising prices. The faster the rate of inflation, the more frequent
these changes must take place and, of course, all of these changes cost money each
time a price rise occurs.
It is likely that the consumer will ultimately face the bill for ‘menu’ changes.
2.
Decision-making
Consumers use prices to make decisions about what to buy. If prices are changing
rapidly then consumers will find the decision-making process more difficult,
undermining the ability of the price mechanism to allocate resources efficiently in a
market economy. When inflation really takes-off, rational comparisons become
extremely difficult since prices can change at an alarming rate. Consumers in this
situation will throw whatever money they have in the direction of sellers to get their
hands on whatever they can before prices go up again. Critical analysis of what
constitutes value for money disappears.
Activity:
Check back into unit 1 to remind yourself how resources were
allocated by the price system. Do you see why confusion caused by
rapidly changing prices can result in the wrong signals being sent to
markets?
Rapid inflation, or hyperinflation, has occurred in many countries around the world
this century, notably after World War One in Germany, Austria and Hungary. In
Europe today very high inflation rates have recently been experienced in Russia and
Turkey.
Businesses also find inflation a problem for the same kinds of reasons as consumers
do. They need to make decisions about what to pay the owners of the resources they
employ and the prices they charge for their goods and services. If prices change
frequently, then their ability to make informed rational decisions will be jeopardised.
Plans for the future become almost impossible when inflation is rampant. Anticipating
future costs and revenues is even more difficult than usual and decisions to invest in
new projects or in business expansion become little more than a lottery.
3.
International effects
Countries with inflation will find their competitive position in the world diminished.
The price of exports will rise, whilst goods and services from the rest of the world
will appear to be much cheaper. If they have fixed exchange rates, then their
economies will decline and lower levels of national income, output and employment
will result. If they have flexible exchange rates, then inflation will result in a
depreciation of the currency vis-à-vis the rest of the world. As a consequence of this
depreciation, import prices are likely to rise, which would make the domestic inflation
problem even worse.
Inflation certainly has a destabilising effect on international economic relationships.
There will be further consideration of these, and other international issues, in unit 11.
4.
Income redistribution
Inflation can arbitrarily make some groups in the economy better-off at the expense of
others. People on fixed incomes, such as those people living on pensions not linked to
inflation, will obviously suffer as prices and incomes in the rest of the economy rise
with inflation. The purchasing power of savings that had been put aside for the future
will be eroded unless it is invested in assets that keep pace with inflation. Wages and
profits will tend to rise in line with inflation, but weaker groups will suffer at the
expense of the more powerful. Strong employer groups may be able to restrict wage
rises to below the rate of inflation, whilst strong unions may secure wage increases,
for their members, at levels above the rate of inflation.
In times of inflation borrowers usually do better than lenders. They can repay their
debts more easily as their incomes rise broadly in line with prices, whilst the value of
their debt is unchanged. This is an arbitrary re-distribution of income away from
lenders towards borrowers.
Employers and employees involved in wage negotiations will also be affected by
inflation. If an employee anticipates inflation of 3% next year, then he or she may ask
for a pay rise of 6%, which would mean a 3% rise in their ‘real’ income. If the
employer anticipates 6% inflation next year they may agree to the wage demand. If
inflation actually turns-out to be 3%, then the employee wins and the employer loses.
If inflation is 6%, then it is the employer who will be more pleased at the outcome.
This redistribution of wealth between different parts of the economic system happens
by accident, may not be desirable, and is due to inflation.
5.
The functions of money
Serious inflation may threaten the essential functions of money. When money loses
value rapidly, then the function of money immediately at risk is the ability to settle
debts by payment in the future. The faster is the rate of inflation, the less likely it is
that credit will be offered since everyone will prefer cash now to cash in the future.
Businesses that rely on credit, such as banks, may try to compensate for high inflation
rates by raising interest rates to match inflation. This doesn’t necessarily solve the
problem since interest rates may have to change very frequently and there is also a
distinct possibility that borrowers and lenders will anticipate different rates of
inflation in the future causing a redistribution of income between them.
The next function of money to be threatened will be the ‘store of value’ function.
Savings and wealth in the form of money will lose value during times of inflation.
When inflation gets really serious the value of savings can be wiped-out. Even money
in interest-bearing accounts is unlikely to be safe since inflation rates often exceed
interest rates on deposits, particularly in periods of rapid inflation. In such times,
people will withdraw money on a large scale from banks (often causing liquidity
problems for the banking system) and try to buy assets that will act as a better store of
value. This de-stabilises the financial markets and will cause panic-buying in other
markets such as the gold and gemstones markets. This is often referred to as a ‘run on
the banks’.
Activity:
With your knowledge of bank balance sheets from unit 8, state exactly
why large-scale cash withdrawals from the banking system pose a
problem for banks.
The two remaining functions are the ‘medium of exchange’ function and ‘unit of
account’. When inflation is completely out of control and prices are changing by
thousands of percentage points a year then these two functions will also be at risk.
Eventually there will come a time when nobody wants to be paid in ‘money’ since it
has little or no value. Buyers and sellers will look for other alternatives. Historically,
people have turned to precious metals, tobacco and a range of other commodities. In
Russia recently the US $ has been preferred to the rouble as a means of settling many
debts because the rouble has become virtually worthless.
When people stop using money to settle debts it becomes pointless to price things in
money terms and so money will lose this function too if inflation is serious enough.
Inflation can spell the end of the financial system as we know it. If it is serious
enough it will destroy normal business activities, wipe-out the value of people’s
savings, bring financial institutions to their knees and probably bring political
upheaval as well. It is not surprising that we consider inflation to be something that
should be avoided, and that politicians regard it as ‘public enemy number one’.
UNEMPLOYMENT
Unemployment can be explained in an individual industry, or for an individual
market, by microeconomics. However, when there is a general rise or fall in the level
of unemployment, which affects nearly all markets at the same time, then we are
dealing with a macroeconomic phenomenon.
We should recognise that there are different types of unemployment that occur in an
economy and then we can focus on why certain types of unemployment are more of a
problem than others.
TYPES OF UNEMPLOYMENT
1.
Frictional
In a healthy market economy, some people will always be moving from one job to
another in response to market signals. People who are currently in-between jobs and
who are unemployed for a period until they find the next one, are placed in the
category of ‘frictional unemployment’. There will always be a certain percentage of
the workforce in this position every year, this is a normal and healthy occurrence.
People leaving schools and universities, seeking full-time work for the first-time, may
also experience a period of unemployment before finding a job. They too would be
placed in this category.
Some people, for one reason or another, may spend long periods looking for work and
this is obviously not quite the same thing as being temporarily between-jobs. It is
common practice now to differentiate between the long-term unemployed and those in
the process of moving from one job to another.
2.
Structural
This kind of unemployment is due to the changing industrial structure that may occur
over time. Certainly in the UK in the latter half of this century, we have seen some
dramatic changes in our industrial structure. Traditional industries such as mining and
shipbuilding have almost disappeared completely whilst new industries based on new
technologies have sprung-up. These changes may be caused by a variety of factors
such as international competition, advances in technology, changing tastes and
fashions, increased incomes and so on, but the result is the same, some industries
decline and the workers in those industries become unemployed. When ‘old’ jobs
disappear we have structural unemployment.
Structural unemployment often has a regional effect. When a mine closes then the
effect may be felt very sharply in one village. The closure of a shipyard will affect the
community of the town where it was located. There may be very little opportunity for
alternative employment in the area and the skills possessed by the unemployed are
unlikely to match the needs of new expanding industries. Structural unemployment
may be a long and painful business.
3.
Cyclical
The ‘trade cycle’ has been a feature of economic life for centuries. During the
upswing in the cycle economic activity increases and during the downswing, activity
decreases. Cyclical unemployment comes and goes with the cycle. Every few years
we will see unemployment rise for this reason.
We do not really understand what causes trade cycles but we seem, these days, to be
experiencing flatter cycles with shallower ‘troughs’ and less dramatic ‘peaks’ which
should reduce the scale of cyclical unemployment. Another development is that
recessions seem to be relatively short-lived in recent times compared with the earlier
part of the century. This may be partly due to the increased emphasis placed on
management of the economy since World War Two. Whatever the explanation behind
it, a more stable economic environment reduces the seriousness of cyclical
unemployment.
Activity:
Unemployment statistics are released every month. Note the latest
figures when they are featured in the media.
What is meant by full-employment?
There will never be zero unemployment. There will always be a certain amount of
frictional and structural unemployment even when the economy is booming. We refer
to this level of unemployment as the natural rate of unemployment.
PROBLEMS OF UNEMPLOYMENT
Naturally, unemployment creates a number of different problems. These are both
economic and social in nature.
1.
Lost output
Unemployment has an opportunity cost, which is simply the goods and services that
could have been produced by those people had they been working. The economy will
not achieve its full potential if unemployment is above the natural rate. GDP will be
lower than it could have been and this has implications for everyone in the economy.
2.
Lost incomes and wealth
Individuals who are unemployed will suffer a reduction in income unless the benefit
system is very generous to them. This means lower living standards, or maybe
growing indebtedness, which will affect them and their families.
The long-term unemployed have little opportunity to save and accumulate wealth to
provide for the future. They are more likely to be dependent on the State to finance
their housing needs and to provide services which many of those in work are
increasingly providing for themselves, such as health care and pensions.
3.
Government finances
Benefits claimed by the unemployed are a significant part of the social security
budget. More unemployment will mean more government spending in this area. In
order to finance high levels of unemployment the government will probably have to
consider ways of raising revenue which means higher taxes for those in work. If
unemployment is reduced then the social security bill can be reduced and
government’s financial problems can be eased. More people in work means more
income tax revenues and other tax revenues too as those working people are now able
to spend more.
4.
Human capital
As far as the economy as a whole is concerned, labour is a key resource. The
economy needs the right amount of people with the right levels of skill and
knowledge in order to reach its potential. Long-term unemployment can undermine
the quality of the workforce. The skills and knowledge possessed by an individual can
quickly become outdated in a fast moving economy. Some people will get out of the
habit of working and may find it difficult to readjust to a working environment. High
levels of long-term unemployment represent an erosion of human capital.
5.
Social consequences
When large numbers of people have no work there are bound to be social problems. If
there is a high level of youth unemployment, it may result in a dependency culture
that is hard to escape. Civil disorder and criminal activity are likely to increase. The
costs to society are great in money terms and in other ways too.
Unemployment amongst older members of the workforce may lead to despondency
and resignation to a future without work. This is likely to be accompanied by a
decline in living standards, which will affect all of the members of the family and
could result in severe hardship.
Clearly, unemployment is something we would like to minimise for a number of very
good reasons.
ECONOMIC GROWTH
Economic growth is the engine that increases the output of an economy and, with it,
incomes and consumption expenditure. Most people are in favour of increased
incomes. With higher income levels you can buy more of the goods and services on
offer in the economy and possibly enjoy a better life-style. People in less developed
parts of the world see economic growth as the means to achieve the living standards
enjoyed by those of us who live in affluent economies. Growth however, is not easy
to achieve and may bring problems too.
Activity:
List some of the problems caused by increased economic activity in a
country.
In order for economic growth to take place, certain conditions have to be present in a
country, so here are some of those important conditions.
1.
Natural resources
Although there are examples of countries which have experienced rapid economic
growth in the absence of abundant natural resources, such as Japan, natural resources
can be very useful in laying the foundations for growth.
2.
Entrepreneurial skill
In a market system we depend on entrepreneurs to see opportunities, create successful
businesses and increase output, employment and incomes in our economy. The
environment for this activity must be ‘right’ to encourage it. Too much regulation by
government or a punitive tax regime may discourage entrepreneurial activity and
damage growth prospects. Evidence suggests that when it is allowed to flourish, the
economy gains and grows. More people are employed, more goods and services are
on offer and more wealth is created.
3.
Capital
Modern economies thrive on capital. There must be an essential infrastructure in
place, particularly concerning transport and communications, if rapid growth is to
occur. Establishing such an infrastructure may take time, and it will certainly require
capital.
Modern manufacturing is capital intensive. In order to participate in the global
economy, the quality of a country’s capital stock is extremely important. Sufficient
investment must take place to create new capital if growth is to be sustained.
4.
The labour force
If economic growth is to take place, a skilful labour force is an important ingredient.
Workers need to be available in the right numbers with the right skill levels to meet
the needs of the market. This century we have seen large, and deliberately
encouraged, migrations of workers to countries such as the USA, Canada and
Australia to complement their other resources and contribute to economic growth.
Not only does growth require a good labour force to be available, the labour market
needs to be flexible in order to respond to market signals so that new businesses can
blossom and flourish.
5.
Financial systems and markets
Without the involvement and support of financial institutions economic growth is
unlikely. Although financial markets are increasingly global, there is still a strong
relationship between the development of financial markets in a country and the
growth of its economy. Hong Kong and Japan are two outstanding examples from the
twentieth century. Developing an efficient financial sector is a long and difficult
process. Many of the countries formally in the eastern bloc, such as Romania and the
Ukraine are finding out just how difficult it is to set-up such a sector.
Activity:
6.
Think of the range of services offered by financial institutions that
make it possible for businesses to start and subsequently grow.
Consumer markets
The characteristics of the consumer market are determined by a number of factors.
The size of the population is one obvious starting point. A large, fast-growing
population is not an advantage to a country wishing to achieve improvements in
economic growth as many developing countries, such as China, have acknowledged.
Average incomes need to be high enough to create the demand for consumer goods
and services that will fuel economic growth. Incomes also need to be fairly evenly
distributed, in order to create mass markets. In order to sustain high growth rates
consumers must be keen on spending, that is to say, they should have a high
propensity to consume.
7.
Political and social stability
Instability is a major block to economic growth. It destroys confidence, restricts
investment and, in the case of civil unrest or war, may destroy capital. Recent events
in the old Yugoslavia serve as an example of what instability can do to an economy.
National income can fall dramatically reducing incomes, employment, output and
living standards. Political and social stability is a pre-requisite for economic success.
International investors look for political and social stability as key factors in their
investment decisions.
8.
Economic management
In a mixed economy, one of the roles of government is to take responsibility for the
economy and balance the nation’s ‘books’ sensibly. If the economy is run prudently
then the scene is at least set for the possibility of economic growth in the future.
Failure to live within one’s means has dire consequences. Governments that spend too
much run up debts that eventually have to be repaid, a process that is likely to result in
some painful economic policies sooner or later to sort-out the mess.
Whilst economic growth can occur in spite of economic policy failures it will
certainly be stronger, and last longer, where good management exists.
Economic growth requires many ingredients, but where they do all come together the
citizens of that country can look forward to financial improvements in their lives. If
we consider living standards in Japan after World War Two and compare them with
now, we can see the powerful economic impact that growth can have within a single
generation. Other countries in the far-east have experienced rapid growth. In
Singapore and Malaysia, living standards have improved dramatically for millions of
people and average earnings have increased beyond what most observers would have
thought possible in such a short time.
Failure to achieve economic growth can be seen as a significant problem for many
countries.
Activity:
With a growth rate of 4% per annum, in real terms, how many years
would it take for incomes to double? (Remember that growth will be
compounded).
NEGATIVE ASPECTS OF GROWTH
Economic growth is only achieved at a price. Not everyone supported the industrial
revolution in the UK two hundred or so years ago. People often left the countryside to
live in squalid conditions in towns, working for low wages in dangerous
manufacturing industries. The landscape became littered with slum housing, unsightly
cotton mills and other factories often belching out smoke and fumes. Cities developed
with little or no regard for a clean water supply or public sanitation. Disease and
epidemics were commonplace. Critics of the industrial economy that provided such
enormous growth for the UK at that time were clearly, often painfully, aware that
growth has its drawbacks.
Today, many people around the world are concerned with some of the consequences
of economic growth. Let us consider some of them briefly here.
Industrial pollution is a major worry in many areas, threatening the very future of the
planet itself. Increased economic activity will bring increased pollution.
Higher average incomes lead to higher levels of car ownership, which in turn means
more traffic pollution and congestion.
The destruction of rainforests in pursuit of economic growth is another area of
concern for many people. The danger to the planet through global warming was
acknowledged by most countries of the world at the recent ‘Earth Summit’.
In addition to using huge amounts of the world’s hardwood we use other resources
which are often non-renewable such as coal, oil and gas, which poses a question
regarding the sustainability of our market economies.
Many observers see large numbers of people caught-up in an economic system
behaving like mice on a treadmill, forever trying to achieve more and more economic
growth. Such observers comment on the social and human consequences of growth,
asking whether growth is synonymous with progress.
In the last twenty years, as many of the major economies of the world have matured,
some critics have called for an end to the relentless pursuit of growth with all its
environmental and social implications. Perhaps it is time to look beyond national
economies and concentrate on the global economy.
It would seem that both economic growth itself, and a lack of economic growth
present problems that should concern us all. This is an apparent conundrum that needs
to be resolved.
CONCLUSION
In this unit we have looked at three economic problems that affect the citizens of
every country wherever it may be. We have seen the damage that can be done by
inflation and unemployment, and we have also seen the benefits of economic growth.
The costs of growth should also be considered as we make choices over how to lead
our lives and the alternative courses of action to take for the future.
Hopefully, the issues involved in each of these areas are now clearer and their
importance highlighted.
We are moving on, in unit 10, to look at the role of government in the economy and
the policy instruments that governments can use to try to deal with the economic
problems that confront them.
REFERENCES FOR UNIT 9
Begg , D et al, Economics, McGraw-Hill, 1997, 5th edition, Ch 27, Ch 28 and Ch 30
Dowd, Kevin, 'The Damage Inflation Does', The Economic Review, Nov 1995
Evans, Philip, 'Unemployment in Britain', The Economic Review, Sept 1996
Murray, Kate and Gore, Chris, 'Inflation and Unemployment: the changing views on
the trade-off between Full Employment and Stable Prices', ACCA Students'
Newsletter, May 1992
Needham, David and Dransfield, Robert, 'What are the limits to growth?', Business
Studies, Oct 1994
Parkin, M et al, Economics, Addison Wesley Longman, 1997, 3rd edition, Ch 22
Sloman, John, Essentials of Economics, Prentice Hall, 1998; Ch 7