Governments set economic objectives - Discuss the relative importance of each of these objectives - Can governments meet all these targets at once
Q. Governments set economic objectives. Discuss the relative importance of each of these objectives (discussed so far). Can governments meet all these targets at once?
The economic objectives the UK government aims to achieve, which have been discussed so far, include maintaining a low level of unemployment, price stability and steady level of inflation and high yet sustainable levels of economic growth. Each economic objective will be analysed in turn and discover its importance in the UK economy.
Unemployment measures the amount of people that are actively seeking employment at a point in time. Typically in the UK, unemployment is measured by the number of people claiming benefits, even though there are other techniques of measuring unemployment. Equilibrium in the labour market exists when the demand for labour is equal to the supply of labour.
Figure 1.0 - Labour market in equilibrium
Even in equilibrium, there may be some level of unemployment, such as frictional and search unemployment, seasonal unemployment and structural unemployment. Sometimes, the labour market moves out of the equilibrium.
Figure 2.0 - Disequilibrium in the labour market
In Figure 2.0, the wage rate is above the market clearing wage rate, P, thus, causing fewer workers to be demanded by employers because the wage rate is too high, yet an extension in the supply of workers because the wage rate is so high. This has resulted in unemployment, which is the distance from QD1 to QS1. If the wage rate fell back to price P, then the labour market would be back in equilibrium as firms would demand more workers and some workers would have dropped out of the labour market, not working due to the lower wage rates.
There are several types of unemployment: cyclical, real wage [also known as classical], frictional and search, seasonal, structural and voluntary.
Cyclical unemployment is closely linked to the business cycle.
Figure 3.0 - The business cycle
There are four parts to the business cycle: the boom/peak, recession, slump and recovery/expansion. At the boom, GNP will be high, as will consumption and investment. Due to high demand, disposable income is high, as are profits and wages. Recessions occur when incomes and output begin to fall. Demand for goods and services fall, thus workers start to be laid off. This is illustrated in Figure 4.0 below.
Figure 4.0 - Cyclical unemployment
In the slump, unemployment levels are the highest and business failures increase, In the recovery stage, income and output begin to increase, firms invest more, consumers spend more, firms are able to take on more workers, therefore unemployment falls and employment rises. For instance, after the recession of 1980 - 1982, unemployment fell from 3.3 million in 1986 to 1.7 million in 1990, based on a claimant count.
Real wage unemployment occurs when the wage rate is too high [see Figure 2.0]. If the real wage rate rose to P1, this would lead to the supply of labour greater than the demand for labour. People are willing to work at that wage rate but are unable to find employment, thus unemployment exists. In the 1970s and 1980s, many semi-skilled and unskilled male workers were caught in the poverty trap: taking on a low paid job would lead them to lose as much or even more in state benefits than they would gain in ages after tax. Although successive reforms of the tax and benefits system in the 1980s and 1990s led to some improvement in this situation, effective marginal rates of tax and withdrawals in benefits remained high at low incomes. Trade unions have also been blamed for creating real wage unemployment during the 1960s and 1970s. They were able to raise wages for their members above the market clearing rate for the labour market, but only by reducing the supply of labour and thus reducing the number of jobs on offer,
Frictional unemployment occurs when people are moving in-between jobs. It may only last a few weeks, however, if it over a longer period, it is known as search unemployment. Frictional and search unemployment rose in the 1960s and 1970s because of the significant rise in the late 1960s of the replacement ratio, the ratio of unemployment benefits relative to wages. This meant that workers could now afford to remain unemployed longer, searching for the right job.
Examples of seasonal unemployment include construction work, agricultural and holiday industries where demand is less in the winter months - these workers are only unemployed at certain times of the year. This is why unemployment figures are seasonally adjusted.
Structural unemployment occurs when there are changes in the whole structure of the economy. This usually occurs when there is a decline in a leading industry. Structural unemployment tends to affect certain areas of the country e.g. Wales has been hard-hit by the decline of the coal mining industry; Yorkshire and Humberside have similarly experienced a decline in several primary industries, including steel.
Voluntary unemployment occurs when people are unwilling to work at the current wage rate. This suggests that in an economy, we will not get to the point of full employment. Instead, we can lower the natural rate of unemployment. The natural rate of unemployment is the proportion of the workforce which chooses voluntarily to remain unemployed when the labour market is in equilibrium.
The government chooses to tackle unemployment as there are many costs of unemployment. The costs to the unemployed include the loss of potential income; some feel degraded by the whole process of signing on to receive benefits; studies suggests that those that are unemployed suffer a wide range of social problems, including marriage breakdowns, as well as health and mental problems; evidence suggests that the longer the period out of work, the more difficult it will be to become employed again. Costs of unemployment will also be carried by the taxpayers: governments will have to pay out increased benefits and taxpayers will have to pay more to cover increased government expenditure and also to make up the taxes the unemployed would have paid if they were in work are only two costs the taxpayers will have to bear. In the UK Budget 2002, £115 billion was spent on social security out of a total managed expenditure of £418 billion compared to £65 billion spent on the NHS. Unemployment, particularly amongst the young, leads to increased crime, violence and vandalism, which destroys the local community. Areas if high unemployment tend to be run down, which would have a knock-on effect to potential businesses which may now refuse to set up in a run down area, thus reducing the opportunity of increasing employment within the area. Finally, unemployment bears a cost to the economy as a whole. There is a loss of potential output - if they were in work, more goods and services would be available for consumption. Furthermore, there are social costs such as increase violence and depression which have been already discussed.
There are two angles at which the government can achieve its objective of lowering unemployment: demand management and supply side policies.
If unemployment is caused by too little demand within the economy, then the government could choose to implement demand management policies to increase aggregate demand. The 1950s and 1960s became the era of demand management, where unemployment levels were extremely low by historical standards. If the economy was below full employment, the government intervened to raise aggregate demand and eliminate the output gap. In order for the government to increase aggregate demand, it can increase government spending, reduce taxation or relax controls on the availability of credit by loosening monetary policy.
Figure 5.0 - Demand management
The extent to which increasing aggregate demand would work within the economy would depend upon where the aggregate demand curve lies on the aggregate supply curve before the demand curve moves. Furthermore, increasing aggregate demand could have an effect on the price level within the economy. For example, if the aggregate demand curve was at AD1 to begin with and the government increased aggregate to AD2, employment has increased but price levels have remained the same. However, if the economy was currently at AD2 and wished to increase aggregate demand to AD3, not only would this create an increase in employment, but it will also create an increase in the price level. If the economy was at AD3 and wished to increase aggregate demand to AD4, similar effect can be noted: employment increases, and so does the price level. If, however, the economy was at AD4 to begin with, and wanted to increase aggregate demand, as the aggregate demand curve is now on the inelastic area of the aggregate supply curve, 'full' employment has been achieved, thus increasing aggregate demand will have no other effect other than on the price level.
Some economists see the demand management theory as rather simplistic. It does not take into the account the natural rate of unemployment. In addition, classical economists argue that the aggregate supply curve is vertical, thus any increase in aggregate demand would only cause inflationary reactions.
Supply side policies can be used to directly target a particular type of unemployment.
The government can deal with frictional unemployment by improving the flow of information to unemployed workers, thus improving employment services. Additionally, by reducing the benefits of the short-term unemployed and improving the mobility of labour, frictional ...
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Some economists see the demand management theory as rather simplistic. It does not take into the account the natural rate of unemployment. In addition, classical economists argue that the aggregate supply curve is vertical, thus any increase in aggregate demand would only cause inflationary reactions.
Supply side policies can be used to directly target a particular type of unemployment.
The government can deal with frictional unemployment by improving the flow of information to unemployed workers, thus improving employment services. Additionally, by reducing the benefits of the short-term unemployed and improving the mobility of labour, frictional unemployment can be reduced.
Keynesian economists believe that governments should try to attract industries into certain areas by giving incentives to set up in certain areas to overcome structural unemployment. They can also increase spending on infrastructure and retraining for workers unemployed by industrial unemployment. This, however, was a failure when Korean company, LG, was given an incentive by the European Union Funding to set up in Newport. Millions of pounds were spent in setting up factories ready for the company to move in. Now there stand empty factories as LG pulled out of the contract. Classical economists believe that market forces will come into play and so automatically lead to lower prices for factors of production, thereby attracting businesses to rundown areas.
Reducing benefits and paying subsidies to companies that take on the long-term unemployed will reduce real wage unemployment; however, classical economists believe that reducing trade union power and introducing minimum wages will ease this problem.
The natural rate of unemployment can be reduced according to classical economists, by making the economy produce more efficiently. Keynesians believe that increased investment in both human and capital projects will improve the situation.
The second government economic objective is low inflation. Inflation is the general rise in prices and there are three theories of inflation: demand pull, cost push and the Monetarist explanation.
Figure 6.0 - Demand pull inflation
Demand pull inflation is the Keynesian view of inflation. Keynesians believe that inflation is caused by changes in real variables - there is excess demand in the economy. The increase in demand could have been caused by four possible factors: an increase in consumer confidence, increase in investment due to the rate of return on capital increases, increase in government spending or a rise in exports due to strong economic growth in other countries.
In Figure 6.0, if output increases from Q1 to Q2, the price level also rises from P1 to P2. This rise in output will cause a fall in unemployment. An increase in aggregate demand from AD2 to AD3 again increases output and causes the price level to rise. At AD3, the economy is in full employment. If there is a further rise in real expenditure, the aggregate demand curve is increased again to AD4, where the quantity of real output, Q3, is the same as when the demand curve was at AD3, however, the price level has risen, leading to a rise in inflation with no rise in output or fall in employment. By increasing aggregate demand when the demand curve is on the inelastic area of the Keynesian aggregate supply curve, the only thing that is rising is the price level as the economy is at 'full' employment.
Cost push inflation, which again is a Keynesian theory, is similar to the demand pull theory of inflation, only here we are dealing with the fact that increases in costs of production can cause inflation.
There are four main sources of increased costs: wages and salaries, imported good, profits and taxes.
Wages and salaries account for 70% of national income and hence, increases in wages are normally the single most important cause of increases in costs of production.
An increase in the price level of finished manufactured imports [e.g. cars, televisions] will lead directly to an increase in the price level. An increase in the price of semi-manufactured goods and raw materials used as component parts of domestically produced goods will feed through indirectly to the price of domestically produced goods.
Firms can raise prices to increase profit margin. The more price inelastic the demands for the goods, the less will such behaviour result in a fall in demand for goods. However, if all firms raise their profits to increase their profit margins, the result have an inflationary impact on the economy.
The Government can raise indirect tax rates or reduce subsidies which will increase prices.
Keynesian economists have argued that a cosh push spiral can develop with leads to a long term cycle of inflation. Consider a developed economy with zero inflation and a few natural resources. International commodity prices of products [e.g. oil, gas, coal, etc] increase by 50% in one year. This has caused domestic prices rise by 10%. Workers will now be 10% worse off in real terms so they will press for higher wages. If, in the past, they have been accustomed to receive a 2% increase in real wages per year, they will be prepared to settle for 12%. Firms pay the 12% and pass on the increase in their workers wages in the form of higher prices. This fuels inflation. The following year, trade unions will once again fight for pay increases of 2% plus the rate of inflation. In the meantime, the profits of firms will have been declining, in real terms. Thus, firms are likely to attempt to increase their profit margins in money terms, again fuelling inflation. This whole process is known as the wage price or cost push spiral. Figure 7.0 overleaf shows how an initial rise in costs lead to a chain of wage increases and increases in demand, which feed back to increases in costs, hence, the short run equilibrium level of prices in the economy is constantly moving upwards.
Figure 7.0 - Cost push inflation
The final explanation of inflation is the Monetarist theory. Monetarists believe that inflation is demand-pull nature and that the sole cause of inflation is a rise in the money supply. Milton Friedman once said "Inflation is always and everywhere a monetary phenomenon".
The Monetarist theory can be explained using the quantity theory of money:
MV = PT
Where M is the money supply, V is the velocity circulation of money, P is the price level and T is the number of transactions over a period of time [or level of real output]. PT represents the value of everything on which money is spent. Monetarists believe that V is fairly constant in the long run. They also claim that, whilst T is not constant, it does tend to grow at a predictable rate. The 'trend' growth rate in the UK is currently 2.5%. More particularly, monetarists believe that the long term 'trend' growth rate is determined by the position of the vertical long run aggregate supply curve which, in turn, is determined by supply side polices.
In the long run, if V is constant and T is at least predictable, then any significant change in the money supply [M] will cause a similar change in the price level [P]. Figure 8.0 below illustrates how an increase in the money supply leads to increased prices.
Figure 8.0 - Increases in the money supply [Monetarist theory]
When there is an increase in the money supply, there is an increase in aggregate demand, therefore a shift of the AD curve from AD1 to AD2. In the short run, there is an increase in output and a small increase in the price level. However, in reality, workers do not want top work extra hours, therefore they demand higher wagers. This shifts the AS curve from AS1 to AS2. This could keep continuing, however the economy will keep returning to equilibrium, but at the expense of higher price levels. Prices would have risen, but output remains unchanged as in the long run, the aggregate supply curve is vertical, thus any increases in demand will only be inflationary.
Keynesians disagree with the Monetarist hypothesis. Keynesians argued that the rise in inflation was caused by factors in the real economy: demand pull and cost push. The money supply would then expand to accommodate the increase in aggregate demand, i.e. Keynesians believed the link was the other way around: increase in price caused by the real economy caused increases in the money supply and not increases in the money supply caused increases in the price level. Keynesians also argue that the initial shift in aggregate demand is only small, there increases in the price level is only small and not great enough to be classed as inflationary.
The UK government chooses to maintain a steady level of inflation and currently set their target at 2.5%, despite recent statistics showing that the rate of inflation is approximately 1.9%, as inflation can bring several economic costs.
Shoe-leather costs are one of the costs inflation can bring. At times of rising prices, consumers and firms will be less clear about what is a reasonable price - this leads to 'shopping around' which is a cost [mainly time - the time could have been spent working, therefore possible wages]. High inflation also erodes the value of cash, and households and firms are then forced to spend more time transferring money from one account to another to maximise the interest paid which again is a cost of time.
Inflation brings menu costs. Restaurants and shops will have to change their prices, and firms will have to calculate new price lists in order to receive the equivalent real income. There will also be changes to fixed capital [e.g. vending machines, parking meters] to take into account the increased prices. All these changes will be costs within themselves.
There are psychological and political costs to inflation. When there are increased prices, people feel worse off as the value of the their money has eroded. The distribution of income and wealth becomes disturbed which then in turn affects the existing social order in society.
Inflation can redistribute income and wealth between households, firms and the state. These costs are known as redistributional costs. Anyone on a fixed income, such as pensioners, will suffer most as the real value of their money would have been reduced. Workers who fail to negotiate pay increases will have less real income and will also be worse off. If interest rates fall due to inflation, savers will be worse off, however those who have mortgages and loans will be better off, in the sense that they have less to pay back. Taxes and government spending will have to change in line with inflation which could mean that those that receive social security benefits will feel worse off due to the value of their income has eroded.
Inflation can have a big impact on unemployment and growth and considering the government wishes to reduce unemployment and promote economic growth, keeping inflation at a low level would become ideal. Inflation creates unemployment and lowers growth. There are increases in the costs of production and creation of uncertainty which lowers profitability of investment and makes businessmen less willing to take risks with investment. The lower investment becomes, the less long term employment there is available. Inflation also interrupts the balance of payments. If inflation is greater in the UK than other countries and the value of Sterling on the currency markets remains the same, exports will be less competitive and imports will become more competitive. Thus, there will be less jobs in the domestic market and less growth.
There are two views of controlling inflation - the Monetarist view and the Keynesian view. The reasoning behind a particular type of inflation will influence the policy measure that is used to control inflation. Monetarists will believe that an effective way to control inflation is to control the money supply [i.e. use monetary policy]; however Keynesians believe that controlling aggregate demand and aggregate supply will be more effective for controlling the real variables that influences inflation.
In the late 1980s, the Conservative government used the Monetarist view of controlling inflation. It did lead to a fall in inflation, however, it lead to a fall in output and employment and thus not favourable to people. Inflation occurs because increases in the money supply are over and above the real rate of growth in the economy - see Figure 9.0 overleaf.
Figure 9.0 - Increase in aggregate demand leading to an increase in the price level
The government imposes tight monetary policy. A restrictive monetary policy means that there will be a fall in the supply of money relative to the demand for money. They will try to increase the amount of money they hold by selling non-monetary assets or by borrowing money. This increase demand for funds will lead to interest rates rising, which reduces consumption and investment. The imposition of a tight monetary policy means that money supply is now less than the demand for money.
Figure 10.0 - Liquidity preference [demand for money] after imposition of monetary policy
The fall in demand for money has now caused consumption and investment expenditure to fall. The restrictive monetary policy leads to a fall in aggregate demand, therefore reducing inflation. The demand for money now equals the supply of money.
Figure 11.0 - Fall in aggregate demand after imposition of monetary policy
Monetarists argue that controlling inflation is relatively simple to do, however governments prefer not to use this method as it can cause unemployment and low growth, thus not good for the political party to gain votes.
Keynesians argue that controlling the money supply is not always the best method of controlling inflation as they argue that there is no precise relationship between the money supply and inflation. Tight monetary policy can also lead to increased inflation in the short run [raising interest rates will lead to higher mortgage repayments, therefore inflationary].
If inflation is caused by demand pull reasons, then reducing aggregate demand will reduce the inflationary pressures on the economy. Figure 12.0 shows that if inflation is caused by aggregate demand from AD1 to AD3, then prices would have risen. If the government can reduce aggregate demand to AD2, prices will begin to fall.
Figure 12.0 - Reduction of aggregate demand
The main variable the government can control is government borrowing [PSBR - Public Sector Borrowing Requirement]. This can be done by either reducing government spending or by increasing taxes.
If inflation is caused by cost push reasons, the government can use incomes policy. The government can control indirect taxes and they can reduce the expected rate of inflation by not indirect taxes in money terms. Basically, it involves controlling wage rises and so stopping the aggregate supply curve from shifting further to the left. This will make cost put inflation less likely. This was used in the 1970s following the union inspired wage spirals. This is obviously something that Monetarist economists who prefer free markets, believe in as it disrupts the free working of labour markets.
Professor AW Phillips published "The Relation between Unemployment and the Rate of Change of Money Wage Rates, 1861 - 1957" in 1958. He examined data from 1861 to 1957 and found that there was a stable relationship between unemployment and the rate of change of money wages [i.e. there is an inverse relationship between inflation and unemployment]. This meant that it was impossible to have low levels of unemployment and low levels in changes in money wages at the same time. The trend he identified became known as the "Phillips" Curve.
Figure 13.0 - The short run Phillips Curve
Money illusion is the belief that prices are stable when in fact they may not be. Inflation may be occurring, but as it is so low, economic agents are not realising it; e.g. if the rate of inflation is 2% and workers ask for a 2% increase in wages, the workers may think they are 2% better off, where in real terms, their real wages have no changed at all. They would then be said to be suffering from money illusion.
When economic agents realise that inflation is occurring and is actually eroding the value of their money [income and wealth], they may change their behaviour. For example, workers will negotiate their wages in real terms, so if the rate of inflation is 2% and the workers want a 2% increase in their wages, the will advance for a total of 4% wage increase.
Figure 14.0 - The long run Phillips Curve
Assume that PC1 is the original Phillips curve. Workers and firms assume that there will be no price changes and the economy is in equilibrium at point A.
The government now increases aggregate demand which causes a fall in unemployment and an increase in the rate of inflation from 0 - 5% i.e. the point A move along PC1 to point X on the PC1 curve. If workers are suffering from money illusion, the point X will move back down the curve back to point A. However, if workers no realise [which is more than likely] that there is inflation and the expect unemployment to rise by 5% per annum, workers will push for higher wages which leads to higher prices. However, this causes real wages to fall [due to this 5% inflation] and workers drop out of the labour market. As the rate of inflation is now permanent at this 5% and has caused unemployment to increase, the economy is now at point B on the PC2 curve.
If the government decides to try to reduce the level of unemployment below the natural rate of unemployment by reducing aggregate demand, output increases and unemployment falls. As this causes an increase in the price level [i.e. there is inflation - workers will push for higher wages, therefore increasing the prices again, assuming that people are not suffering from money illusion]. This is the point X in Figure 14.0. As higher wages are demanded, this shift the point onto the PC2 curve which increases unemployment but keeping the 5% inflation. Therefore in the short run, unemployment falls and the rate of inflation increases.
However, what would happen if the government tried again to reduce unemployment via government spending? Assume we start at point B in Figure 14.0 due to the fact that the government has already tried to reduce unemployment in the past. When the government increases aggregate demand, point B would move to point Y where there is a fall in unemployment but a further increase of inflation by 5%. If economic agents are suffering from money illusion, the point would fall back to point B [the natural rate of unemployment], causing the economy to be in the same state as previously. However, if the economy does not suffer from money illusion, workers push for higher wages, leading to higher prices. Due to a fall in real wages, people begin to drop out of the labour market, therefore moving the point Y to PC3 at point C, where unemployment is back to its natural rate, but with the consequence of a permanent increase of inflation to 10%.
Economic growth is increases in potential output of the economy and can occur if previously unemployed resources are employed, there are more resources or resources improve in quality.
Increases in productive capacities are known as economic growth. As it is impossible to measure the productive capacity of an economy directly, economists tend to use changes in GDP, the value of output. Using GDP, however, can be misleading, particularly in the short term. An economy can operate below or above its productive potential over a period over a period of time - it tends to follow the business cycle. For example, in times of a recession, unemployment rises, therefore the country fails to produce its maximum potential level of output. The trend rate of growth is upward sloping and approximates the growth in productive potential in an economy. However the actual level of GDP at any particular time may vary from the general trend line. The difference between the actual GDP and the trend line is known as the output gap.
Figure 15.0 - Production Possibility Frontier
If a country has unemployed resources, it may be able to increase its output by a significant amount. If, however, its resources are fully employed, it will have to rely on increases in resources or more likely, increases in the quality of resources
There is conflict between consumption and investment. Economic growth can be achieved by increases in investment, but increased investment is at the expense of expenditure on consumption goods.
National output can be increased in the quantity or quality of the 4 factors of production: land, labour, capital and technological processes. Output can also be increased if existing inputs are used more efficiently.
We must remember that land in economics is defined as all natural resources, and not just the land itself. Many oil producing countries, in particular Saudi Arabia have experienced large growth rates mainly due to the fact that they are so richly endowed. The UK itself did not start to exploit its oil resources until the mid 1970s, and today, oil only contributes to 3% of our GDP. Some economists argue that the exploiting raw materials aren't such a significant source of growth in developed economies and are more significant to the developing countries.
Labour is perhaps considered to be one of the most important and influential factors that affects economic growth. In theory, if labour increases, this should lead to economic growth. Increases in labour can result from several factors:
. Changes in demography - if more young people enter the workforce than leave it, then the size of the workforce increases
2. Increases in participation rates - in the UK almost all of the increase in the labour force in the foreseeable future will result from women returning to, or starting work
3. Immigration - e.g. employing migrant labour
4. Sufficient education [e.g. literacy, numeric and computing skills]
5. Flexibility [requires a broad general education as well as in-depth knowledge of a particular task]
6. Workers need to be able to contribute to change - e.g. every worker can contribute ideas to the improvement of technique of production.
The stock of capital in the economy needs to increase over time if economic growth is to be sustained. This means that there must be sustained investment in the economy. However, increase investment does not necessarily mean an increase in growth. For example, investment in a new hospital is unlikely to create much wealth in the future. Furthermore, investment can also be wasted if it takes place in industries that fail to sell products. Therefore investment must be targeted at growth industries for it to be worthwhile.
Technology is becoming an important part of life and no doubt, it is highly important to an economy's growth in 2 ways: It cuts the average cost of production of a product and it creates new products for the market. Without new products, consumers would be less likely to spend increases in their income and without increased spending; there would be less or no economic growth.
In the case of the UK, it is thought that potential output is likely to increase by approximately 2.25% per year as a result of improvements in technology and education. The government prefers stable growth to periods of boom and recession as these create uncertainty and can be destabilising, so they prefer a situation where demand matches potential output and they can steadily increase with each other.
Economic growth in the UK was 0.1% in the first 3 months of 2002. This weak growth figure seems likely to confirm fears that the UK economy is still far from economic recovery. Although the growth rate compares favourable with zero growth rates in the previous 3 months, it was lower than economists were expecting which was about 0.4%. The low growth rate also means that the Bank of England will be less than likely to raise interest rates in months to come. Output in the service sector, which makes up the bulk of UK plc, was flat during this time period, whilst manufacturing output was sagged. The service sector grew by 0.5% compared to the same time last year, where it was 2.5%. Growth in services is heavily dependent on High Street spending which has slowed down, according the Office for National Statistics (ONS). The UK's manufacturing output declined across all major sectors, and the output of production industries is estimated to fall sharply once more.
Economic growth brings a number of advantages, especially as more goods and services will be available, these may be of a higher standard, thus, improving the standard of living. Absolute poverty has practically been eliminated in Westernised countries. This has caused life expectancy to double over 300 years and infant mortality rate to plummet. People have enough to eat and drink and housing standards have improved drastically. Furthermore, nearly everyone can read and write.
However, economic growth may also bring several disadvantages.
Figures are not always seen as true representations of growth. This is because years ago, much of the output produced was not traded. Furthermore, wages have increased but the output produced has remained the same. People not only consumer more goods but they also have increased leisure time, which to some people is more important than anything of monetary value.
The pool of migrant workers that economic growth has created has lead to falling family values, increased crimes rates and increase rates of broken families. In one view, it has broken down our society.
There are many environmental issues that accompany economic growth. Each percentage growth rate uses up non-renewable resources. Resources would eventually run out and also pollution affects the planet through the o-zone layer collapse and the greenhouse effect.
Despite some disadvantages, the government pushes for economic growth [innovation, research and development], etc. Thus, the government can use two policies to encourage growth: interventionist policies or the free market approach.
Some economists believe that the market mechanism is unlikely to lead to optimal rates of economic growth. There are so many forms of market failure that the government must intervene in the market place, hence the use of interventionist policies.
To increase economic growth, the government can increase public expenditure on education and training, through subsides for training and increasing the legal requirement of firms to undertake training with all 16 to 18 year old. The government can subsidise investment: direct subsides or grants could be use if investment is undertaken. They could also reduce the cost of borrowing by reducing interest rates, or they could encourage savings thus increase the level of investment undertaken. By funding university research and establishing research institutions, the government can encourage economic growth. The encouragement of monopoly power can encourage innovation which is another policy the government could use. The last interventionist policy possible is the protect infant industries as they are unable to take advantage of economies of scale. Once these industries are large enough, the government can take the free market approach and allow market forces to determine their stance.
Even though using interventionist policies will encourage economic growth, there are limitations to interventionism. International agreements [GATT, WTO and the EU] limit the amount of intervention the government can use e.g. the UK can not place quotas or tariffs on any imports from another EU country. In addition, political pressures lead to governments abandoning policies such as monopolies and nationalisation in preference to freer markets.
Government intervention is seemed as ineffectual. They are not the best to judge which type of training is the best: if companies do not train their workers, this does not mean that they will receive lower rates of return. Companies could be using scarce resources more productively. Additionally, investment encourages capital investment at the expense of labour intensive industries.
Under a free market system, governments should provide more choice. Students should have to pay for their own tuition so that they will be more inclined to work hard and use their skills. Allowing businesses to decide upon their own training requirements and increasing the number of TECs should be encouraging. Investment, in the free market approach, is best left to private industry. They will have the best knowledge or high yielding projects. Governments may only be encouraging investment in poorer areas which may not yield such a high rate of return. The size of the state should be as small as possible and should only be there to allow a free market to exist. It also needs to provide public goods. Protectionism and monopoly allows inefficient firms to remain in the market. They exploit the consumer. Thus free market ideas are at the heart of supply side economics.
It is virtually impossible for the economy to achieve all the three economic objectives discussed all at once. There will be conflicts and consequences when aiming to achieve economic objectives.
One particular conflict is between employment and inflation. The Phillips Curve which was discussed earlier on suggested that these two variables have, in theory, an inverse relationship. If a government tries to reduce unemployment through reflationary measures, such as lower interest rates or increased public spending, then the resulting reduction in unemployment will push wages higher [as employers try to attract workers from a diminishing pool of the unemployed]. This will lead to higher prices. On the other hand, when the government tries to control high inflation with higher interest rates and reduced spending, the resulting reduced consumer spending and lower investment will result in job losses. Norman Lamont, Conservative Chancellor of the early 90s, famously said "...unemployment is the price worth paying for lower inflation."
Another conflict which can be identified is the conflict between economic growth and inflation. If an economy grows too quickly, especially if it is due to excessive consumer spending as it tends to be in the UK, then demand will outstrip supply and prices will rise. Equally, the steps taken to keep inflation low, like relatively high interest rates, can often restrict growth via reduced consumer spending and investment. It is difficult to achieve both aims. The 'trend' rate of growth is seen as the rate of growth an economy can grow without igniting inflation. Most economists believe that this is around 2.5% to 3.0% at the moment. For the last six years the UK has managed to walk this tightrope without slipping into either higher inflation or recession. Perhaps the economic cycle has been eliminated, but most economists find this difficult to believe.
How the government prioritises these objectives could be dependent on a number of variables. One important factor is the economic view the government adapts [i.e. is it Keynesian, Monetarist or Classical?]. This is because, in particular with inflation, the governments' views and theories of certain concepts will lead to their reasoning for their actions to achieve their targets. Depending on what measures the government will use to achieve these targets, one may find that there may be no conflict. For example, typical use of supply side policies has few large impacts on the economy which could offset another economic objective.
Full employment was considered very important after the Second World War. It was probably the number one objective of the socialist government of the late 40s and continued to be at the front of politicians' minds for the next three decades. Unemployment exploded under Thatcher in the 80s, but it was seen as an inevitable consequence of the steps taken to make industry more efficient. It was painful at the time but the lower levels of unemployment today are due, in part, to the structural changes made in the 80s.
The fact that deindustrialisation was occurring throughout the western world also made higher unemployment feel inevitable. Thus, this objective became much less important than it had been.
Growth and low inflation have always been important. Without growth, peoples' standard of living will not increase, and if inflation is too high then the value of money falls negating any increase in living standards. Nowadays these are definitely the two most important objectives of UK macroeconomic policy. The Chancellor is always going on about 'sustainable growth', meaning growth without inflation. Probably the biggest piece of economic news each month is the decision taken by the Monetary Policy Committee [MPC over interest rates, their sole objective being the 2.5% target for the growth in RPIX [plus or minus 1%]; a target that is still the responsibility of the Chancellor.
On growth, there tends to be periods of strength [booms] followed by periods of weak or even negative growth [recessions]. All governments have a goal of eliminating this cycle. In other words, they want continual, reasonable growth that never ignites inflation, perhaps 2.5% - 3% per annum.
Notice that the growth rate has been over 2% without getting out of hand for six years. Following the 'bust/boom/bust' of the 'early 80s/late 80s/early 90s', this is quite an achievement.
Inflation has also been remarkably subdued by historical standards. Following the horribly inflationary 1970s [peaked at 25%] and the near 10% figure ten years ago, RPIX has been growing at 3% per annum or less for six years.
The goal of full employment has effectively been consigned to the history books. Unemployment reached one million in the 1980s for the first time since the 1930s, and then proceeded to reach 3 million [or 4 million, depending on the definition] within three years. Having said that, 'full employment' does not mean that everyone has a job. Even in the 'full employment' era of the 1950s there were still 300,000 unemployed. Today's figure is falling towards one million which some consider to be fairly close to full employment given the large amount of structural unemployment. This fall has been possible due to supply-side reforms of the Conservative governments of the 1980s and the increased flexibility of the UK labour market, both of which have reduced the number of structurally unemployed people.
If one had to pick the most important objective today, it would have to be inflation. Although it should be growth, all government's efforts are devoted to the control of inflation. If this goal is missed, it is felt the goal of higher growth will not be attainable either. However, "prevention is better than cure". Inflation is cumulative: that is, say inflation for January 2002 was 1.8% and by September 2002 it was 1.6%, this does not mean that prices have fallen. It means that prices are simply not rising as quickly as they were compared to January 2002. It would require deflationary measures to lower the price level. The government can only stop prices rising so quickly, but preventing them rising so rapidly is what the government is aiming for.
Alison Ng 13JK
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