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The UK economy and Tesco's Positioning

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The UK is one of the largest macroeconomys in the world. It is seen to be one of the strongest and most stable economies at the present time, which from the evidence in this discussion seems set to stay for the future.

Economic growth

The definition of economic growth is an increase in Real GDP (gross domestic product), which is usually calculated annually. Therefore in order to calculate economic growth, GDP, which is the total value of production in an economy, needs to be calculated. There are three ways of doing this, the expenditure method, the income method and the output method. There are small discrepancies between the values of GDP using each method, and so in the UK the official measurement used by the government is an average of all three methods.

The below graph shows the economic growth rate since 1980.

Figure 1

image00.png

Source data: IMF, World Economic Outlook Database, September 2006

As we can see, in the early 1990s, the UK suffered from a recession, as economic growth was negative for more than two consecutive quarters. Between 1991 and 1992, the economy actually shrunk, and real GDP fell. This can be linked to other leading indicators, which will be considered later. However, since this time the UK has achieved steady and sustainable economic growth, which has been one of the highest rates in Western Europe, allowing the UK to be competitive. This economic growth has probably been aided by an expansion in the labour market, due to the influx of migrants into the UK. The government is expected to exceed its target of 2.75% growth this year, and this is likely to continue for the foreseeable future. It would seem that this can only be positive for the UK economy, improving individuals’ standards of living and helping to increase confidence in the economy, increasing investment and therefore increasing aggregate demand. However, economic growth also has costs. Inflation can be caused if the increase in Real GDP exceeds the rate that aggregate supply can increase, which can be seen on the diagram below.

Figure 2

If Long Run Aggregate Supply cannot increase, then the inflation rate will rise, which can cause many problems for the economy. The UK will need to be careful that this does not happen, as inflation has been on the increase, which I will now look at.

Inflation

Inflation is the annual percentage increase in prices. There are a number of ways of calculating inflation; in the UK the two main measures used are the CPI and the RPI.

Today the UK inflation target is based on the Consumer Price Index (CPI), which was previously called the UK Harmonised Index of Consumer Prices (HICP). The CPI inflation target is set at 2%. The Retail Price Index (RPI) is still published; it differs from the CPI as it includes a number of extra items, mainly related to housing, including council tax and mortgage interest payments. I will be examining data from both measures as the CPI has only been used since 1997.

Figure 3

image01.png

Source data: ONS

As we can see, in the past, the UK economy has had problems with very high levels of inflation in the past, especially in the 1970’s which was caused by massive oil price rises. The inflation rate rose sharply in the early 1990’s, nearly reaching double figures again. This could have caused the negative economic growth and the recession in the economy seen on Fig 1. However, since then the UK economy has achieved a steady inflation rate, that until recently has been below the Bank of England’s of 2% for the CPI. However, now inflation seems to be on the increase. In November the CPI rate was at 2.7%, with the RPI rate at 3.9%, the highest rate in a decade.

November's annual rate of inflation is the highest since the UK introduced the CPI as its main measure of inflation in 1997, and was driven by an increase in transport costs and a smaller decline than expected in fuel and energy costs.’ (BBC News).

The consistently increasing house prices have also had a major impact on the inflation rate, as can be shown on the following figure.

Figure 4

image02.png

Source: First Release: Consumer Price Indices, November 2006, National Statistics

This rising inflation could cause problems for the UK economy. Public sector wage negotiations are due in early 2007, which use the RPI inflation rate as the basis of pay increases. Increases in wages as high as the RPI figure of 3.9% would be likely to create further price growth, due to increases in demand that would arise.  However, due to recent falls in the price of oil, and the slowing down of the housing market, inflation will probably not reach the levels that it has in the past, and will remain fairly steady in the future. Also, when looking at inflation, other countries rates of inflation need to be considered. The UK's rising inflation rate will cause exports to be more expensive, decreasing demand in the economy, and reducing the UK’s competitiveness, which could lead to the closure of firms. However, it needs to be remembered that the inflation rate is relative to that of other countries, if other economies have a high inflation rate then the UK’s competitiveness would not be affected. However, Eurozone inflation is very low currently at around 1.6%, and so the UK may suffer in the international economy from having a high rate of inflation.

It has been seen recently that Monetary Policy has been used to aid the inflation rate, which I will look at later.

Unemployment

Unemployment is defined as the proportion of the working population that are not in work, but are actively seeking employment. It does not include those not seeking work, for example those raising children or in full time education over the age of 16, these are classed as the economically inactive, and so are not included in the working population.

There are two methods that the UK government uses to quantify the level of unemployment, the Claimant Count and the Labour Force Survey.

The Claimant Count measures unemployment by the number of people that claim Job Seekers Allowance. This method may be inaccurate, mainly because not everyone who is unemployed claims unemployment benefits, and so underestimates unemployment.

The Labour Force Survey (LFS) is carried out quarterly by the International Labour Organisation (ILO) and is a survey of around 60,000 UK households. It records the number of people who are available for work, are without a paid job and have looked for work within the last four weeks. It is considered to be the most accurate measure of unemployment as it is used by many countries and so comparisons can be easily made. This is the official measure used by the current government.

Figure 5 shows data for both measures for the last 25 years.

Figure 5

image03.pngSource data: ONS

In the early 1970s when we earlier saw very high inflation on Figure 3, unemployment was at a very low level. This is backed by theory by A.W. Phillips, who suggested that a trade-off exists between inflation and unemployment, that if one was high then the other would be low and vice versa. The UK struggled with unemployment during the 1980s, peaking at a rate of 12%. This was probably related to structural change in the economy at the time, manufacturing activity halved during the period between 1978 and 2003. However, once structural unemployment had settled, and supply side policies had been introduced in order to increase labour flexibility, we can see that unemployment has been steadily declining over the last ten years. It is this that has lead to the economic growth that we saw on Figure 1.

In recent years, and in the future, unemployment would seem to be on the increase. The unemployment rate in 2006 is 5.5%, which is forecasted to increase to 5.7% in 2007. However, this is probably not going to be a problem for the UK economy. The actual number of people in employment has been constantly increasing, and the UK still has one of the lowest unemployment rates of any developed economy, especially compared to some Eurozone countries that have struggled with high unemployment rates recently. It is one of the governments’ aims to achieve full employment, which it has already in some areas, for example the South East where claimant count unemployment is under 2%. However, the slight increase in the unemployment rate suggests that the UK still has some way to go before it can meet this target, and perhaps more job opportunities need to be created in order to improve the current position.

Balance of payments

The Balance of Payments is a record of transactions between one country and the rest of the world. In the UK it is split into two main accounts, the current account and the capital account. When adding the values of the two accounts together, and allowing for errors, the total equals 0, and so it is important that the focus should be directed at the current account, rather than at the overall balance of payments.

Figure 6

image04.png

Source: IMF

We can see that for over 20 years, the UK’s current account balance has been negative, and so we have imported more than we have exported. However, this is not necessarily detrimental for the UK economy. The strong pound means that imports are more attractive, and exports seem expensive abroad and so the balance of goods stands at a £20.5bn deficit. However, Britain runs a surplus on trade in services which helps to reduce the current account deficit, which stands at £9.4bn. The UK also gains the largest amount of FDI (foreign direct investment) of any country in the world, showing that the economy can still be strong whilst having a current account deficit. The deficit is currently at a low rate which is steady, and is forecast to decrease relative to GDP.

Exchange rate

The exchange rate mechanism is very important in the UK. London has the largest foreign exchange market in the world. The London foreign exchange market accounts for over 60% of the global turnover of foreign exchange.

An exchange rate expresses the value of one currency against another. The exchange rate in itself is not considered to be a key macroeconomic objective, but needs to be considered due to its impact on other key aggregates.

Figure 7 shows the nominal exchange rate of the dollar against the pound, two of the worlds most important currencies.

Figure 7

image05.pngSource data: Bank of England

In the past, the exchange rate has been quite volatile, which is likely to have been negative for the UK economy as it would reduce confidence. However, the weak pound seen in the early 1980s may have had some benefits for the UK, which can be seen on Figure 6. A weak pound would mean that exports would be cheap compared to the USA, and imports would seem expensive, and so the current account was positive during this period. However, a strong exchange rate that we can see at the present time may be seen as a sign of a strong economy, and so the UK, as we have seen is more likely to gain inward investment.

Interest rates

Interest rates are set by the Bank of England’s Monetary Policy Committee monthly in the UK. The MPC decides whether interest rates should go up, go down or stay the same, their decision is based on ‘the objective is to keep aggregate demand as far as possible in line with the productive capacity of the economy’.

Figure 8

image06.png

Source: Bank of England

Although interest rates seem to have been high in the past, this is relative to the levels that they started at, and they did not have such a prominent role in controlling the economy as they do today. At the beginning of this century, interest rates were very low, encouraging consumer spending and aiding the expansion that has been shown. However, in order to make sure that this is controlled, interest rates have recently been increased to their current level of 5%. So far, this doesn’t seem to have calmed down the economy to the wanted level, and so a rise to 5.25% is expected in the first quarter of 2007. This would be likely to decrease the inflation rate to its target, as less will be spent and more will be saved. However, there are concerns about increasing the interest rate, mainly to do with the overestimated US slowdown.

Tesco is the UK’s largest retailer with 1779 stores in Britain. They take one out of every eight pounds that is spent in the UK. They are not only a retailer of foodstuffs, but also provide many other goods and services, including clothing, home wares, entertainment products, financial services and telecoms. We can first look at income elasticity’s of demand to see how vulnerable and exposed Tesco is.

image07.png

As can be seen, the income elasticity of demand for Tesco’s main area of business, ‘Food, Drink and Tobacco’ is very low and inelastic at around 0.25, suggesting that the business is not vulnerable to macroeconomic shocks. This low income elasticity figure is due to food being a necessary good, and so Tesco would not be badly affected by increases in unemployment or rises in inflation.

However, if we look at the Financial Services sector which Tesco has branched out into, we can see that it has an elastic income of elasticity of demand, and so is more vulnerable and exposed to macroeconomic shocks, and so Tesco may need to use more than one strategy to manage uncontrollable external shocks.

By diversifying their product and service range they have achieved economies of scope. By doing this, they can reduce the average cost of all their products, therefore increasing profits, and so reducing any impact that shocks may have. This also means that if demand, for example clothes decreases, demand for telecoms may increase, and so they will not loose profits.

Finally, an important strategy for Tesco will be to build up loyalty. At the moment, public perceptions of Tesco are declining, according to two leading advertising and market research groups. If Tesco can try and improve its customer loyalty, then its products will become less income elastic, and so be less vulnerable to macroeconomic shocks.

Bibliography

  • BARRELL, R. , KIRBY, S. & RILEY R. “UK Economy Forecast” National Institute Economic Review, No 198, October 2006,  NIESR
  • GRILLS, S. (2000) Notes for OCR Economics 2000-01: AS3 The National & International Economy, www.digitaleconomics.co.uk

Webpage’s

  • www.statistics.gov.uk
  • http://news.bbc.co.uk/1/hi/business/6175273.stm
  • http://news.bbc.co.uk/1/hi/business/6171617.stm
  • http://news.bbc.co.uk/1/hi/business/6216848.stm
  • http://news.bbc.co.uk/1/hi/business/5127006.stm
  • www.imf.org
  • www.tutor2u.com
  • http://business.guardian.co.uk/story/0,,1976805,00.html
  • www.oecd.org

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