Free Economics NotesBy Kevin Bucknall BSc(Econ), PhDCopyright 2012 Kevin Bucknall potx

Both these policies are used to alter the level of aggregate demand the total level of private spending on consumption and investment, plus government expenditure , and then adding in e

Free Economics Notes

By Kevin Bucknall BSc(Econ), PhD

Copyright 2012 Kevin BucknallPublished by Kewei Press at Smashwords

ISBN 978-0-9561823-3-3

The cover photograph was taken in Japan during the Meiji period by the famous Japanese photographer Enami about 1892-95 It shows women winding silk in what seems to be cottage industry Photograph by courtesy of http://www.t-enami.org/services

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Chapter 1 An Introduction to Economics in 5,000 Words and a Bit

Chapter 2 Trying to Make Sense of Economic Policy—Part 1: What Do Governments Try to Do?

Chapter 3 Trying to Make Sense of Economic Policy—Part 2: Why is it so Difficult to Get it Right?

Chapter 4 Business Cycles, Recessions and Economic Booms

Chapter 5 Understanding Economics: a Summary of the Advantages and Disadvantages of the Price Mechanism

Chapter 6 Notes on the Difference Between “Economic Growth” and “Economic

Development”

A free sample from the book Going to University: the Secrets of Success

Other books by this author

Videos by this author

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This free eBook is a collected set of articles and notes about economics that I wrote over the years to help my students Some of the material was prepared for students at school who were working towards university entrance; some was designed for students who were already studying at university at the undergraduate level and, in the case of the research chapter, at the postgraduate level You can pick and choose what interests you and concentrate on what you find useful The search function in eBook readers and word processors is pretty good for finding what you need I hope you find at least some of it both interesting and useful

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Chapter 1 An Introduction to Economics in 5,000 Words and a Bit

Authors Note

Many years ago when I was doing research as a Visiting Associate Member at St Antony's College, Oxford, I shared a house with several grad students from various different disciplines who were studying for their D.Phil I was struck by the number who asked me what economics was about and would I please write an elementary piece some day, so that an intelligent and well-educated person could learn what it was about I never forgot This chapter is a simple introduction to the discipline, or at least as simple as I can make it Economics courses tend to contain a lot of mathematics or a lot of diagrams,

or both This chapter uses neither It might be useful to you if you are similarly

intellectually curious; or if you are just starting a course in economics and looking for an easy overview; or perhaps are contemplating studying the subject and wondering what the heck you might be getting into If it interests you and you would like to learn more, please check out my free book An Introduction to Economics that sticks to using diagrams with only the tiniest bit of algebra in one small section.

What is economics?

Economics is a subject notoriously difficult to define clearly for outsiders: a formal

definition might be that it is a social science that deals with the production, consumption and distribution of goods and services In simpler terms it deals with how people produce and work, in order to survive in this world Mainstream economics covers things such as how prices are determined in the market; how best to organise the economy for efficiency and growth, and what sort of things can prevent a perfect solution; how wages are

determined; what causes undesirable events like inflation and unemployment and what can be done about them; and how and why countries interact through foreign trade and foreign investment

Sciences attempt to be value-free and objective; economics is no exception, and for this reason words like "ought" or "should" tend to be avoided, as they are “normative” and the discipline sticks to facts which are “positive” It has to be confessed that it is harder to be completely objective in the social sciences, dealing as they do with human beings and their behaviour, than in the natural sciences, most of which are concerned with the

inanimate world and non-human life forms

In life we constantly make choices and each time we decide to do something, let us call it

"X", then we choose not to do something else, we can call "Y" Economists refer to this as

the opportunity cost, i.e., what is given up to get what is actually chosen It is most

clearly seen when constructing a budget and deciding how to allocate money between competing uses, but it applies everywhere Opportunity cost lies behind all financial cost calculations and cost curve diagrams: the cost of buying is the amount of money that has

to be paid by person A to get to use the stuff (iron ore, the service of a worker, a delivery truck ) rather than let someone else (person B) use it

The study of the economy is traditionally divided into two sections, microeconomics,

which looks at a bit of the economy (think of looking down a microscope at something small), especially prices, what firms decide to do about price and output decisions, and

wage determination Then there is macroeconomics, which looks at the entire economy

and as such is concerned with things like the size of total output, the level of inflation, the amount of unemployment, and foreign trade We will look at these in turn

Microeconomics: the determination of prices in the market and the system known

as the price mechanism or the market mechanism

When I started out in economics we students used to be taught to chant in unison "Prices are determined by supply and demand" and no doubt some still are If we think of some item (again we shall call it X) if no one wants it at all, then it has no price—there simply is

no demand Probably a wrecked and burnt out car would fit this description If some people actually want X then it will have a price, as whoever owns X can sell it and use the proceeds for some purpose or other Will the price be high or low? It all depends on supply and demand Think of an auction: if there are three old pianos for sale and twelve people really want to buy one, the price will be bid up and up, and therefore be high Supply and demand! But if there are thirty pianos for sale and again twelve people want a piano, the price of each will be lower That is the way that prices are roughly determined in the world Economists use diagrams or mathematics to show and analyse this in detail

An increase in demand occurs if at a later auction some eighteen people turn up wanting a

piano and there are still only three instruments to bid on This increase in demand leads

to an increase in the price of the pianos

A decrease in demand occurs if at a later auction only four people turn up wanting a piano

rather than the original twelve Assuming we still have three pianos to bid on, this would lead to a lower price than in the week before

An increase in supply occurs when, say, eight pianos appear in the auction rather than

three This increase in supply causes the final price to be lower

A decrease in supply? If instead of three pianos, the number falls, say to one (and with an

unchanged twelve people trying to buy) the “going-going-gone price” will increase

These simple examples illustrate the working of supply and demand, which operates outside auction rooms as well as inside them Notice that the process of the analysis is to start in equilibrium then alter just one element, holding all the other features unchanged

In economics we mostly do this and then look at the result This is referred to as

comparative statics: "comparative" because we compare two equilibrium states; and

"static" because time is not considered and everything simply works through to equilibrium

where things cease to change Dynamic analysis is different as things keep altering over

time A course in elementary economics does not normally get as far as dynamic analysis.There is one objection to the theory of price setting which on the surface seems valid, but

is in fact false Some people object that firms simply decide on what price to set and that

is all there is to it—the theory of price is just wrong However, if we think about it, if a firm sets its price too high it will wind up with unsold stock, which is costly to store; but if

it sets it too low the firm will run out of produce quickly but still have to pay wages, lighting and heating bills etc Either way the firm could do better: it is not profit

maximising If a firm persists in such poor pricing it will go bankrupt If firms want to do as well as they can, they have to set a price that just clears the market, i.e they sell it all apart from the minimum stock they need to hold So it's back to supply and demand! But what if they do not choose to profit maximise? Competition will eventually force them out

of business It is no accident that most economists have an inbuilt urge to promote

competition wherever possible Only those economists paid by organisations trying to cling

on to a monopoly position tend to be against it Are they bad economists? No, just like lawyers, they are paid to promote the interests of their client but they do not have to believe in it We will not even think about political spin doctors

What about the operation of the price mechanism (market mechanism)?

When a firm believes that it could make a profit by producing something, call it X, which

it can sell for a relatively high price the firm moves in and does so This increases the

supply of X and drives the price down As different firms in different industries constantly chase profits in this way, resources (land, labour and capital) keep being reallocated from what they are producing to going into something else, as someone hopes that they will make more profit in the new area In this way, the price mechanism constantly reallocates resources to where they are most needed and high prices (indicating that people want to buy X), along with potentially high profits, act as signals to producers.

Why did I say earlier "this is the way that prices are roughly determined in the world"? It is

rough because various things can get in the way and prevent a perfect solution being achieved, particularly if we are interested in the whole of society Let us list some of these intruding elements

1 Some people own all or most of X so they can dribble it onto the market at a slow rate

and get a higher price as a result (monopoly).

2 Some people do not know what is available and where it is to be bought so they do not

demand X at all (information failure).

3 Some people have a lot of money and others have little or none (unequal income

distribution) so that very expensive cars, watches, yachts and the like are produced—

there is a demand from the rich for these But on the other hand, not enough food is grown and some people are hungry or even starve; these are the really poor, who cannot afford to buy enough food

4 Some people will not move from where they live to get a job elsewhere The result is

that firms trying to expand are unable to find enough workers (factor immobility).

5 Some goods and services are provided in too small quantities for what are perceived as

the needs of society, such as health and education (merit goods) Contrariwise, some

goods and services may be over-consumed for society, perhaps cigarettes and alcohol,

which contribute to ill-health and accidents (demerit goods).

6 Some goods and services might be needed by society as a whole but few individuals are willing to pay for them Examples include the defence of the country, a police force to

protect citizens, a court system for settling disputes, or street lighting (public goods without exclusion) As individuals who choose not to pay cannot be prevented from

enjoying the benefit of such goods, either society goes without or we have to make the people as a whole pay for the service

7 Some goods and services, when consumed, might have an adverse impact on people

other than the person consuming (externalities) Common examples of external

diseconomies are pollution, congestion, noise, and litter Opposite these we see external economies that when consumed by X provide benefit to others These include such things

— Television and radio broadcasting which spread information rapidly—again many

countries provide at least one channel without charge In attempted revolutions and coups, seizing the radio and TV stations is high on the list of the insurgents to control the flow of information

— Health provision: if we quickly treat those with tuberculosis it does not spread to

others So the state may step in

All the above points prevent a free market system from reaching a perfect solution as to what shall be produced and in what amounts.

Wages and wage determination

Wages, like prices, are roughly determined by supply and demand Again it is only

“roughly” as several factors get in the way of a pure market solution The demand for workers comes from firms and organisations who want to hire people to work for them The firm, if trying to be as efficient as possible, hires people until the last person adds less revenue to the firm than it has to pay to that person In the jargon it is called when

the marginal product equals the wage If the organisation pays out more as a wage than it

gets back from the efforts of the individual, clearly it is not maximising profits but losing money

On the supply side of labour there may be all kinds of restrictions

Obvious ones include differences in intelligence, paper qualifications (degrees, diplomas, GCE A-level results ), physical strength, previous experience, and so forth The need to meet such criteria tends to mean fewer people may be qualified or able to do a particular job

We can list a few more general factors that can affect supply and prevent wage equality

1 Non-competing groups: shelf-stackers in a supermarket do not compete for work with

neurosurgeons in hospitals A shortage of surgeons does not lead to shelf-stackers applying

to do surgical operations

2 Trade union and government restrictions may exist that establish a minimum wage The

result of this usually means fewer employed people, but a greater reward for those who can actually find a job

3 Labour immobility: people will not always move to a new job The reasons may include:

— Information failure (people unemployed in locality X do not know about jobs and

conditions that are available in locality Y)

— Local factors that restrict movement, e.g people with a state-supplied cheap house in area X will not give it up to move to area Y

— Pension schemes—workers who have paid into a company scheme for years may lose some or all their pension if they move

— Social groups like family, friends and members of clubs—few people like leaving them and going off to new and unknown pastures

— Knowledge and familiarity with the local scene, so that people know where it is best to

go for food, entertainment, to buy things, or just find their way around If they move they lose this and have to start again

— Racial or religious ties to an area

4 Time lags: it can take years before people become aware of problems locally and

opportunities elsewhere, then consider the matter carefully, and finally decide to change their job or move to a new area

5 Non-monetary rewards: it is clear that not all human beings strive to make as much

money as possible and some will take work that gives them satisfaction at a lower wage If this is not true, it is not easy to explain convincingly why so many choose to become teachers or nurses, or why some drop out of highly-paid positions in the finance industry in order to take up furniture-making and the like

Competitive circumstances and the theory of the firm

As noted, economists generally prefer more competition rather than less Three different states of competition are widely recognised:

1 Perfect competition, which is at one end of the spectrum and, as the name suggests, is

the most competitive situation of all

2 Monopoly, or one firm supplying all (or almost all) of the output is at the other end of

the spectrum; and

3 Imperfect competition (also known as monopolistic competition) which is the bit in the

middle; it is fairly competitive but with some restrictive features

More minor variants, such as duopoly (two firms), and oligopoly (a few firms make up the

industry, a situation that is reasonably common in the world) exist but the main attention focuses on the three above

Under perfect competition, price is the lowest and output is not restricted at all;

resources are well allocated, although of the things that get in the way listed above, the items 3-7 can still produce a less than perfect allocation of resources

Under monopoly, output will be deliberately restricted to achieve a higher price and profits; resources will be poorly allocated, and income distribution will be worsened, as the monopolist really rakes it in

With imperfect competition we are in the middle, i.e some output restriction, middling prices, and resources are reasonably well allocated to the demands of consumers but less

so than with perfect competition There will be some short-term widening of the

distribution of income Some observers claim there will also be faster growth as the term high profits can be used for research and development, and in addition there is enough competition between firms to ensure that each tries hard

a little more; the fourth might get in the way of others and total output might decrease a bit By the time we get to, say, 200 people in the garden they will be shoulder to shoulder and no vegetables will be produced! From this law of diminishing returns we can derive the demand curve for labour, which is needed in wage theory

The decision on how many people to employ and how much capital (the choice of

technique) also derives from the theory of production; simply put, in an environment with

a lot of cheap labour, as found in many poor developing countries, firms use more people

and less capital (labour intensive techniques) but in rich industrialised countries the reverse is the case (capital intensive techniques).

Managing the economy as a whole (macroeconomics)

There are ten major goals, or economic areas of concern, that all governments in all countries may have Each government, and political party, can choose which of them to place stress on, and which to take more lightly Because some of the goals clash, a choice between them is often necessary Each government or party can prioritise all of these in their preferred order but few probably do The way it mostly seems to work is that there

are often a few main policies established and from then on the government tends to react

to events as they arise

So what are these ten main economic goals?

1 Inflation—avoiding or reducing it.

2 Unemployment —often reducing the level, but sometimes deliberately doing the

opposite to cool down an over-heated economy

3 Economic growth—usually we wish to increase it.

4 The balance of payments—either balancing it or aiming for a small surplus.

5 The value of the currency—in the UK this means maintaining the value of the pound, in

the USA the value of the dollar, and so forth

6 Improving the allocation of resources—this often means moving towards a more

competitive market-determined solution; but the government has its own agenda too, such as it may wish to increase resources to education, defence, or the National Health Service

7 The distribution of income—this often means trying to make it more equal, or at least

paying lip-service to this

8 The standard of living—a high standard of living is preferred, so increasing the level is

often a goal

9 Taking care of the environment—this is a relatively new goal, but one that is rapidly

increasing in importance

10 Avoiding unnecessary and undesired fluctuations in the above nine points.

As a quiet bit of fun, take a couple of minutes and pretend you are the person in charge of your country and consider what order of priority you yourself would choose Does your best friend agree with you?

How can governments try to manage the economy?

In a market economy there are only two main ways: monetary policy (altering the supply

of money or the rate of interest) and fiscal policy (altering the level or structure of

taxation and/or subsidies)

In the case of monetary policy, in the UK the government lost the ability to directly alter the rate of interest in 1997 It gave this authority to the Bank of England's Monetary Policy Committee The central goal of this Committee is curbing inflation; it attempts to keep it within one per cent of the annual goal set by the Chancellor of the Exchequer, which is usually two percent The other goals of government are not the concern of the Committee although it sometimes seems to broaden its own remit a little here

In the UK, fiscal policy is administered largely through the annual budget which occurs in April each year Such once-a-year changes do not provide a flexible policy tool but

admittedly some of the effects do come into play quite quickly

Both these policies are used to alter the level of aggregate demand (the total level of

private spending on consumption and investment, plus government expenditure , and then adding in export earnings while subtracting imports,) in the desired direction, if the

government wishes to depress the economy, it reduces aggregate demand which will eventually lower the rate of inflation, increase the level of unemployment, and improve the balance of payments The authorities can do this by increasing the level of taxation (fiscal policy) or the rate of interest (monetary policy) Both measures take money out of the economy: if a family has to pay extra tax it means that less discretionary spending is possible; if the rate of interest is increased it means that repayments on many borrowings,

including the important mortgage repayments, increase (which leaves less in the pocket for consumers to spend) It also means that firms wishing to borrow to expand or to fund the purchase of machinery find it will cost them more, so they postpone it wherever possible thus reducing the overall level of investment.

Why it is difficult to get it just right? (For a more detailed discussion see Chapter 3)

1 Information lags—when a decision has to be made we do not know where the economy actually is at that time, only where it was earlier as revealed by the statistics available

2 Information reliability—errors creep in; there never is totally accurate information available "Garbage in, garbage out" (GIGO) is a reasonably accurate description

3 Different policy measures have different time lags before they take full effect This means that as policy changes some older measures probably have not fully worked

through; then the new measures kick in, and each at different speeds, so we tend to blunder along Hopefully we are going in the right direction although even this is not always certain

4 Some goals contradict others, so that there is no possible way of "getting it right"

anyway As one example, under normal circumstances if we increase the level of

aggregate demand to lower unemployment it tends to increase the rate of inflation This

in turn tends to reduce exports and increase imports, so worsening the balance of

payments It also increases output and tends to widen the distribution of income

5 We are not smart enough to get it right As we are dealing with human beings and they have the freedom to make new decisions and do things differently, it is possible that we never will be clever enough The historical record of what happens when we changed the rate of interest by half a percent may not apply the next time we do it as we will live in a different and rapidly changing world

The foreign sector: trade and investment

The above discussion was concerned with a domestic economy in isolation In reality, no country is alone in the world and few wish to be isolated There is a high economic price

to be paid for isolation: those who cut themselves off suffer slow growth, great

inefficiency, and a low standard of living Most countries choose to trade with others as a result

Why do they do it? What are the gains from trade?

1 Comparative advantage—a country produces what it is good at (agricultural produce,

light industrial goods, services such as banking and finance whatever) and sells these to the world It then imports what it is not so good at from those countries which can

produce the item more efficiently and cheaply This explanation is the main reason for trade If all countries were equally good at everything, why bother to trade? As a personal example, if you are extremely good at playing football and a rotten cook, it pays to earn a substantial income playing sport and eat out at restaurants or employ your own cook Your comparative advantage is on the sports field not in the kitchen

2 Economies of scale—if it is cheaper per item to produce in large quantity, then

countries can specialise in a few things and sell them to others in exchange for things that the other countries specialise in

3 Variety—consumers in a country might enjoy some foreign products, import them, and sell stuff back in return Motorcar production in Europe springs to mind as an example as each country buys cars from the others

4 Sheer absence of an item—it is difficult to grow bananas in Iceland or make

refrigerators in the Saharan desert, so things that are lacking may be imported Not that it

is impossible to grow bananas etc., in Iceland, merely very expensive to do so; this

suggests that this is often really a specific case of comparative advantage

Despite the established benefits of trade, there seems to be a widespread instinct towards insulating the economy from foreign competition, i.e protecting jobs and protecting the profits of domestic companies Each individual sector would like to be protected, although

it does not mind much if all other sectors are not In fact, this would be the best outcome for the small protected part, as it would gain all the benefits of cheaper goods and

services plus rapid economic growth, but without giving up a thing

Since the end of World War Two, economies have gradually opened up and reduced the level protection although not at a steady rate The views of economists, pressure from politicians such as Margaret Thatcher and Ronald Reagan, negotiations via a series of meetings at the international level, and the widespread but not complete collapse of communism, have all played a part

Globalisation is the ultimate stage of this process of opening up domestic economies by reducing protection, increasing foreign trade, and liberalising the flows of foreign

investment The world as a whole benefits from this; but there can be, and there are, losses to some While companies in major, powerful, and rich countries can gain from investing in poor countries, the local people may suffer The influx of foreign capital can easily damage or destroy the existing local industry and agriculture It is a specific case of

an extremely wide income distribution producing a poor market solution in this case on the global scale—the market operates to supply what is demanded by those with the money to spend So with globalisation many of those living in richer countries (including their poor) gain; the world as a whole is better off; but this is scant consolation to those in poor countries who may suffer These are often the poorest of the poor

Is globalisation then acceptable? Is it fair or just? Such questions worry a lot of people It

is an emotive issue in which morals, ethics, and values are often hotly debated Those institutions that work to reduce protection and increase globalisation, such as the World Trade Organisation (WTO), are often attacked verbally and their officials and meetings physically The antagonists are people who hold strong, some would say extreme, views that globalisation hurts the poor and is simply wrong The protagonists say that the world

as a whole benefits and most are better off The reply to this is that some are definitely made worse off, they are already the weak, the poor, and the suffering, and they are not compensated in any way by the greedy and selfish winners Some respond to this view that that is just the way the world is, and in addition, there is no going back The reply to this response may well be unprintable

It has to be stated that economics, and the workings of an economy, are amoral; morality, ethics and justice simply do not appear We believe that the price mechanism, free trade, and ultimately globalisation produce a more efficient system, a higher standard of living, and faster economic growth which all work for the benefit of many But it involves losers

too and these are too often the poorest amongst us and the least able to cope Welfare economics tries to deal with this and considers compensation possibilities.

How do we measure the degree of interaction with other countries?

This is done in the balance of payments, an account that shows our financial dealings with the rest of the world It was traditionally divided into two parts, the current account, which includes trade in goods (the visibles that we can see) and services (things that we cannot see and are called invisibles); and the capital account, which in broad terms

explains how the current account is being financed If imports exceed exports, a country either pays the difference by transferring foreign exchange or else borrows to cover this difference and this shows up in the capital account (A once popular exam question was to explain how the entire balance of payments could be described as in balance when there

was a clear surplus or deficit in the current account; the answer is that someone either pays the debt or still owes it and this is the balancing figure in the capital account!)

Since 1998 the UK has adopted a four part approach to the balance of payments but the distinction between current and capital account persists

1 The current account: the export and import of goods and services plus incomes flowing

to and from abroad, both earned by workers and from investments made

2 The capital account: changes in the financial size of ownership of fixed assets and what migrants bring in and take out as they come and go

3 The financial account: changes in the financial size of assets the UK residents buy abroad and foreigners living abroad buy in the UK

4 The international investment position: the total stock of assets that UK residents own abroad and foreign residents own in the UK

Which part of the balance of payments matters? All of it! We look at the part of the balance of payments that gives us the answer to whatever question we are interested in Having said that, attention mostly focuses on the current account and changes in it, because it shows how well we are currently doing

That's it, economics in a nutshell Warning! It is necessarily a limited explanation and misses out much; it is no more than a simplified, basic introduction to a complex and fascinating discipline There are many articles and books written about virtually all of the individual topics just mentioned If you believe that you have got what you wanted, then you can stop reading now! On the other hand, if you feel that you would like to go further and understand more, then you can download and read my free book An

Introduction to Economics that explains this article in much greater detail It also

provides diagrams to illustrate and help analyse the issues.

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Chapter 2 Trying to Make Sense of Economic Policy—Part 1: What

Do Governments Try to Do?

Note: this is a detailed examination of an issue that was touched on briefly in Chapter 1.

There are several areas of concern for the leadership of a country Domestic politics obviously loom large and are the main area of concern but there are other important issues, such as economics, foreign affairs, defence, and social issues A major reason for taking economic policy seriously is that economic growth provides the extra resources that are needed to spend in these other areas of interest In a very poor country with little or

no growth it is difficult to have much by way of government spending To develop a

comprehensive welfare system, build infrastructure or engage in domestic or foreign wars, requires a lot of resources Without growth, the people of the country would suffer

deprivation in order to pay for such things

All governments need to have some idea of an economic policy, however vague or defined this might be Having achieved power (the first law of politics) and then kept it (the second law), then those in charge will wish to use this power to some purpose

ill-Whether power was gained through a democratic process, taken by military force or inherited, does not affect the fact that power, once achieved, has to be used to do

something Even if a leader is a simple dictator with few aims other than power for its own sake, he still has to make decisions about what is good or bad and what is desirable or not Such matters might be given consideration in their own right or else the views might

be a simple reaction to events arising within the country or abroad

In the economic sphere there are ten areas of concern that governments in all countries might consider and for which they can develop policies or goals Each government need not have a strong interest, or indeed any interest, in each of the ten areas but whether the government has or not, the issues do not go away If what is happening is acceptable

to those in charge, they can choose to ignore it completely However, when something goes wrong or events occur that the ruling elite do not like then a policy is needed to deal with the issue Refusing to develop a policy is itself a decision, in this case to let things slide

What are these ten fields which can require economic policies and decisions?

Listing them, although not in any priority area, the first seven are domestic-related, numbers eight and nine are foreign-related, and the last one is of general application

1 Inflation

2 Unemployment

3 Economic growth

4 Taking care of the environment

5 The allocation of resources

6 The distribution of income

7 The standard of living

8 The balance of payments

9 The value of the currency

10 Avoiding undesired fluctuations in the above nine points

How to prioritize these is an issue for the governing authority, i.e in what order should they be placed and also how strong an effort should be devoted to each There is no "one

size fits all" answer to these issues and the authorities in each country make up their own minds In the real world, it is often the case that inflation and unemployment are taken more seriously and so are higher on the list.

Many governments appear to pursue some or all of the possible goals in a somewhat

uncoordinated fashion and some decisions that help the achievement of one goal can easily make it harder to achieve another Some time ago a British government, realizing the possibility of such contradictions, came up with the slogan of "joined-up government" which meant that a set of coordinated policies should be adopted in which contradictions and anomalies should have no part The catchphrase proved much easier to invent than implement and was quietly dropped when the difficulties involved became apparent Good idea! Next time make it work!

The way many governments approach their job is to start by deciding on a few main

economic policies; in a democracy, these may appear in an election manifesto and, once elected, a government can claim that it possesses a mandate for them Many of the other economic goals tend to be put to one side and perhaps ignored until some event, possibly

a disaster, focuses attention on them In this case a government is reactive, i.e.,

responding to events, rather than being proactive and choosing a direction by means of a definite and acknowledged policy

One rule of thumb is that governments tend to place a higher value on domestic affairs than foreign ones, largely because in democracies at least, voters care more about

domestic issues, especially those that affect them directly These often include health, education, schooling, taxation levels, inflation and unemployment The first three are matters of resource allocation, the fourth is concerned with raising money to spend (again resource allocation) and the final two are what it says on the can

The ten economic policy fields in more detail

In turn, this may promote further investment

More investment means faster economic growth Growth then makes it easier to reallocate resources from where they are less needed to newer areas where they are more needed Changes in consumer taste or fashion as well as the emergence of new inventions,

technology and goods and services means that constant readjustment is normal What was produced last year, as well as the way it was produced, are unlikely to be exactly what is desirable now

In the UK in the early Twenty-First century there was a strong interest in avoiding inflation and the policy was to try to contain it to 2 per cent a year, which is considered to be reasonable price stability A figure higher or lower than this is not wanted although it has happened quite regularly In Zimbabwe, by contrast, there was little or no interest in this goal, or the economy in general, and by 2008 the rate of inflation was probably in the region of 100,000 per cent Domestic politics, i.e his own survival, appeared to be the sole interest of President Mugabe so that a series of unfortunate and disastrous political, social, and economic decisions adversely affected the economy and involved intense social suffering and human rights violations

2 Unemployment

Most governments prefer to keep unemployment at a low level, partly for economic

reasons—more people working means more output—but probably the main motives are political and social The government can lose the support of the people if unemployment

is high; and large numbers of the unemployed can lead to social unrest and the danger of people taking to the streets This can be a problem in both democracies and less liberal countries

Despite this, many governments are prepared deliberately to increase the level of

unemployment in the short term in order to help the attainment of other goals The rate

of inflation and the level of unemployment tend to move in opposite directions, so that if the government wishes to reduce the level of inflation it might deliberately increase the level of unemployment, using fiscal policy (mainly taxation changes) and monetary policy (mainly the money supply and the rate of interest) If the economy is considered to be overheated, when the level of aggregate demand is felt to be too high, one possible

solution is to increase the level of unemployment

These days it is less easy to talk in terms of old-fashioned left wing and right wing politics,

as the differences between political parties have often begun to blur Still, the left wing, the more radical labour party members and trade unionists tend to regard keeping

unemployment low as a more important priority than the right wing, employers or

conservative party members might favour Similarly, the left might be prepared to accept rather higher levels of inflation in preference to increasing the level of unemployment In the United States, the Republican Party tends to be right wing and Northern Democrats more liberal while Southern Democrats are often conservative As far as priorities are concerned, factions within a government or party can be important, as different groups with different ideas struggle to take over the leadership

3 Economic growth

As a long term goal, most governments seem to like economic growth and try to adopt policies to promote it A higher rate of economic growth means that we can enjoy a higher standard of living, it gives us a greater ability to improve resource allocation, and also provides the surplus out of which we can take better care of the environment Against

this, the process of economic growth is frequently bad for the environment, especially by

causing pollution of air and water while increasing the level of noise Environmentalists are particularly worried by such consequences of growth, particularly the short term ones which are rapidly encountered and easily visible; they doubt that governments will

restrain growth in areas of need and are dubious that the extra surplus will actually be used to deal with environmental issues

4 Taking care of the environment

This is a relatively new goal, but one that is rapidly increasing in importance, particularly

as evidence of global warming increases In recent decades, several international

conferences about world environment issues have led to agreements, such as the Kyoto Protocol (1997) to which many, although not all, national governments signed up The environmental goal involves changing resource allocation, for example from oil-fired power generation to wind power, or taxing vehicle fuel at higher rates in an attempt to reduce private use

5 Improving the allocation of resources

Improving the allocation of resources means using land, labour and capital in a different way The changes are often marginal Sometimes, however, they can have a major impact

on a particular group of people, such as coal miners and steel workers, or geographical regions, especially if a particular industry is heavily concentrated in one or two specific areas

In a dynamic economy, resources are constantly being adjusted as producers react to the changing demands of people and new technology emerges For an economist, an

improvement in resource allocation often means moving towards a more competitive market-determined solution and away from distortions caused by monopoly elements or laws and other restrictions But the government has its own policies that it wishes to implement: nearly all of these would alter the allocation of resources It may, for

instance, wish to strengthen education, defence or the transport system but has not the resources to do all three properly Each government will have a different agenda and will also change its mind and alter its priorities in light of new information becoming available, emerging events causing a reaction, or perhaps realignments in the power holders within the party bringing new views to the fore

Government efforts to alter the allocation of resources can include the passing of laws and regulations that promote or limit certain activities; the establishment of quangos (quasi-autonomous non-government organizations); the awarding of contracts; subsidies to

various groups of people or industries (e.g., the UK Disability Allowance which affects labour directly by reducing the pressure on those with physical or mental problems to go out and work); and taxation If the tax on certain products or industries is increased (or subsidies reduced), it might lower consumer demand for the products and in turn reduce the number of firms and workers producing the goods

6 The distribution of income

Income distribution relates to the proportion of people within the country who are rich, in the middle, or poor It is often measured as percentiles or deciles or more formally by using a technical measure, the Gini Coefficient If you want more information you can download a free book An Introduction to Economics as a zipped PDF file

Journalists might present the issue in the form of how much of the country is owned by what per cent of the people As an example, in the USA in the year 2001, the top 10 per cent of the people of the country owned 69.8 per cent of the wealth, compared with 56.0 per cent in the UK in the year earlier Strictly speaking this is wealth distribution, rather than income distribution, but the two are closely related

Improving the distribution of income often means trying to make it more equal or at least paying lip-service to this goal We regularly read that despite efforts there has been little

or no "improvement" in the distribution of income for several decades

Some see "improvement" as meaning “more equal” but for others it seems to be exactly the opposite, i.e., providing greater rewards for those who strive hard and succeed in life This latter view often seems to involve less restriction on creative entrepreneurs and on high-ranking executives in private companies Those supporting this latter view are

frequently wealthy, political conservatives, or else believers in liberalism and economic freedom The result of adopting a policy of greater rewards would be to widen the

distribution of income

7 The standard of living

A high standard of living is preferred by almost everyone One notable exception to this occurred in socialist countries, such as the Soviet Union in the past, where the state had a strong preference for promoting industrialization and economic growth rather than raising the current living standards of the people As a result, wages and prices were fixed at a low level to ensure a just about adequate life for all and the surplus was extracted for reinvestment in the economy Forced industrialization of this kind is only possible with strong central control and restricted levels of freedom; this does not occur in Western-style democracies with their free voting Any government attempting it would be voted out at the next election It is now widely accepted that such a process of forced

industrialization ensures poor resource allocation as well as low living standards and few

countries subscribe to it North Korea is one of the few left to do so and the standard of living is so low that the people are reportedly five centimetres shorter on average than those in South Korea owing to malnutrition.

8 The balance of payments

The balance of payments is the account that shows a country's dealings with the rest of the world It is commonly divided into the current account, revealing the value of the flow

of goods and services, and the capital account, which roughly shows how the current account is financed and deals with capital flows Many governments wish either to balance the current account or perhaps aim for a small surplus A deficit on current account, particularly if large and continuing lowers the value of the currency (violating goal nine) and this weakening is often regarded as a bad thing especially by some politicians The word "weaker" carries negative connotations, although under certain circumstances a lower value of a currency can be a good thing as it promotes exports and can raise both living standards and the rate of economic growth

Even with a substantial current account deficit, if other countries are willing to hold the currency as part of their gold and foreign exchange reserves, the deficit need not be a problem This was the case for the United Kingdom before the Second World War; since then the USA has been like this, running current account deficits and the rest of the world holding dollars By 2007 the dollar had weakened notably and it seemed as if this ability of the USA might be starting to weaken

9 The value of the currency

In much of Europe it refers to the value of the Euro, in Mexico the value of the peso, and

so forth As mentioned, many politicians, and some others, regard a strong currency as a mark of strength and hence it is felt to be desirable A strong currency is one that buys a lot of units of other currencies

What can make it strong?

— The country is successfully exporting a lot, so the current account is in surplus

— Foreigners trust the currency and are willing to hold it as part of their reserves of

foreign currency

— People expect that a rise in the value of the currency will occur and buy in as a gamble

or in investment in order to make a future profit

10 Avoiding unnecessary and undesired fluctuations in the above nine points.

Stability and security are preferred, so that fluctuations, especially unexpected large and frequent ones, are undesirable The authorities often try to prevent or offset a

fluctuation, for example, if the American dollar starts to slide in value, the Federal

Reserve might raise the rate of interest in order to attract foreigners to buy dollars and slow, then reverse, the fall in the value of the dollar

As globalization proceeds, it is hoped that the allocation of resources at the world level will get better This would improve economic growth and the standard of living generally; hopefully it would also improve income levels in poorer countries The latter point is disputed, and the possibility of achieving faster global growth and a higher standard of living for richer countries which is accompanied by little improvement of, or an actual fall

in, income levels and living standards in poorer ones has been suggested more than once Many believe that this is already happening

This increasing globalization transmits international shocks more rapidly than previously and in the future might increase the frequency and size of undesirable fluctuations

Conclusion

Of these possible economic goals, only a few are likely to be central and of major

importance to the authorities; and what is regarded as central can change It is not possible to achieve all of these economic aims simultaneously, either because some goals clash with others or the available resources are too small to allow the pursuit of more than a few of them at any one time For such reasons a choice must be made and the goals placed into some order, however vaguely defined, so that policies can be framed to tackle what is felt to be the core government intentions of the day

~~~

Chapter 3 Trying to Make Sense of Economic Policy—Part 2: Why is

it so Difficult to Get it Right?

The ten main economic goals for any government were discussed in Chapter 2 Here we look at why the task of achieving these economic goals can be formidable indeed

There are at least a dozen reasons why it is extremely difficult—in fact impossible

—to achieve all of our economic goals simultaneously

First, resources are limited so that the government cannot afford to place a great effort

on all of the goals at the same time This means that a choice must be made about which

of the goals are the more important and should be strongly pursued, and which can be downgraded to a lower position, or be placed on the back-burner and ignored for quite some time

Secondly, we simply are not good enough, or know enough, to attain most of these goals

at the same time Perhaps we will get better with time and technology; we can but hope but I confess to pessimism here

Thirdly, there are statistical and interpretation problems The statistics we have to work with are not perfect and some are simply wrong It is common for official statistics to be published, then revised and republished; but the policy decisions are taken on the basis of the earlier and quite likely inaccurate figures GIGO! There are also lags before many of the statistics become available, and even then not all of the relevant series appear at the same time, as some are harder to compile and therefore slower than others to arrive This means that a policy decision may be made with statistics of varying degrees of reliability and in part referring to different periods

Fourth, economic growth does not proceed steadily at an unchanging rate, so the economy

often includes cycles (see Chapter 4) In view of the statistical problems above we often

do not know exactly where we are in the cycle If we think something is happening but we are in fact wrong, all efforts to deal with this "something" might well make things worse Diagram 3.1 explains this The curve of output graphed against time shows what can be expected to happen naturally, if the government takes no action and the dotted red line shows what can happen if the government intervenes but gets it wrong

If our latest statistics refer to time period A, when growth is rapid and inflation is

probably high, the government might take strong action to rein in the economy and slow the economic growth That's fine if we are actually at A, i.e., there is no time lag and there are accurate statistics The result would be we would get it right, manage to

moderate growth, and with any luck prevent the downswing that would naturally start after C

If, however, the statistics are a bit out of date—say we are not at A but are actually at B where the economy has already begun to slow down—then the action taken is likely to be too strong In this case, government intervention to reduce growth would reinforce the slowdown and push us into a downswing earlier than otherwise would have happened (the dotted line) The downswing is also likely to be greater in depth, and possibly in length of time, before the next upswing can be expected

The worst case scenario would be if we are actually at C, with statistics still coming in from the period A In this case the government action to restrain the economy, based as it would be on well out of date statistics, would force a major downturn and could push us into a recession or even a depression which is an even worse state of affairs (see Diagram 4.1) A recession is technically defined as two quarters of the year in a row where there is negative growth—in effect we are sliding backwards There is an old joke among

economists that a slow-down is when you read about someone being unemployed; a

recession is when your neighbour is unemployed; but a depression is when you yourself are unemployed

Governments always face time lags in statistics and knowing this still have to take

decisions To try to get it right they examine several different series—perhaps the most recent figures they can get on unemployment, inflation, production, and exports and imports, as well as surveys of moods of business people, and then compare these with

changes from the previous period On occasion some of the figures conflict, some

indicating a slowdown is coming, others suggesting the reverse, so that fine judgement is required Sometimes it is not clear whether the best course of action would be to expand the economy, contract it, or simply do nothing It is not easy! My own view is that if you

do not know whether to expand or contract, doing nothing is definitely the best option

The fifth problem with attaining the economic targets is connected with the main policy

instruments available to the authorities—fiscal policy and monetary policy Both

instruments have problems attached that may prevent the attainment of desired economic goals, i.e., to get where we want

Fiscal policy: this means using taxation, and to a lesser extent subsidies Usually the aim is

to alter the overall growth of the economy and in particular the levels of inflation and unemployment It can also be focused directly on areas such as altering the distribution of income, the allocation of resources, and increasing the protection of the environment

In many countries, fiscal policies are implemented in an annual budget although a second mini-budget in a year is possible An annual policy change is not a very flexible way of dealing with issues as they arise and therefore the budget can be something of a blunt instrument It probably works better at altering the distribution of income, the allocation

of resources, and protecting the environment than dealing with the overall

macroeconomic policies on inflation, unemployment and growth

Other than this inflexibility, a major problem is that many tax and subsidy levels are difficult to change for social and political reasons; for instance it can be difficult or

impossible to reduce the level of pensions or other welfare payments or to increase the rate of income tax Some taxes and subsidies might have been fixed for a given period by previous announcements or cannot be changed owing to international obligations The discretionary element, the part that the authorities can actually alter, may be quite small

Monetary policy: this means using changes in the rate of interest and the supply of money

to alter the level of aggregate demand This policy is largely used for the overall

macroeconomic targets of inflation, unemployment and growth In contrast to fiscal policy, monetary policy can be altered quickly, perhaps monthly or quarterly as needed, and therefore is flexible However, the affects can be slow to arrive and some of them may take a year or more to filter through completely, reducing the immediacy of their impact

A sixth and related problem is that at the time the actual decision has to be made on

whether take action at all, and what particular action to take, the full effect of measures already taken in the past has probably not yet been felt, and things are still working their way through Allowance may be made for this but in ignorance of how much has actually worked through Tricky indeed!

A seventh problem that prevents the simultaneous achievement of all of our goals consists

of the lags in recognition, decision, and implementation

— Recognition lags: it takes time before people become aware that a problem exists; the statistical problems mentioned above are largely responsible for this

— Decision lags: it takes time to make a decision about what, if anything, to do about the economic problem Meetings may have to be organized, stakeholders consulted, and possibly objectors may need to be pacified

— Implementation lags: once the first two lags are over and a decision is reached it takes time to make any necessary changes and put the new policy into practice There will then

be a lag while we wait for the results to emerge

An eighth reason for our inability to achieve all that we would like is that we are dealing

with human beings who have the ability to change their behaviour or responses and they may no longer follow the pattern established in the past This means that the statistics on previous behaviour that we have accumulated may no longer apply quite as well If people alter their behaviour patterns, it might mean that the authorities make a bad decision out

of ignorance of the new trend

The increasing globalisation means that more countries and people are available to change their minds and behaviour which may make this problem worse

Another reason for it being difficult to devise accurate solutions to tackle and solve

economic problems is that we are not always dealing with hard statistics Part of the information used may consist of projections or estimates rather than actual figures By their nature, projections and estimations are less reliable than facts and might more easily let us down Projections often produce three possible outcomes, high, medium and low One of these has to be selected as the basis of any policy response: flipping a coin is not normally the route chosen but one has a nasty suspicion that sometimes it might give

at least as good a result

A tenth problem is that while we can expect the unexpected, we never know what this

will actually be A sudden external shock can occur—they often do—and it is impossible to build this into the decision-making process Events around us conspire to get in the way, especially international ones We can scream "Help! We've been hit by a stochastic

variable!" but it does not get us anywhere

In eleventh place, we face the cock-up factor Human beings are fallible and make

mistakes; systems are often imperfect; computer programs can contain errors or be unable

to cope with an unexpected event, and so forth This suggests that Murphy was probably right when he formulated his famous Law "What can go wrong, will go wrong." We hear that his wife once said “And Murphy was an optimist!” which is a bit scary

And finally, it is always impossible to achieve all ten goals simultaneously for the simple

reason that some of them interact: to do well at one often means doing badly at another—there is a trade-off involved

So what are these trade-offs?

Which of the economic goals interact, so that an effort to pursue one can have an impact

on and prevent the achievement of another? Let’s list some of the most important ones

Inflation versus Unemployment

Fighting inflation is likely to clash with a full-employment policy: to reduce the rate of inflation a government might raise interest rates, reduce the money supply, and/or

increase the level of taxation This would have the desired effect of lowering the level of demand but would also have the undesirable effect of increasing unemployment The opposite is also the case: striving for full-employment can cause inflation A common problem for a country is that it faces inflationary pressures (which might suggest the government should increase interest rates) and at the same time is suffering high or rising unemployment levels (which suggest that interest rates should be lowered) Ouch!

Unemployment versus the balance of payments

Following a policy of full-employment can adversely affect the balance of payments by causing more imports of consumer goods (because more people are in work, income levels are higher, and people spend more) Imports of producer goods and raw materials (to make some of the things people are now buying) will also increase In addition it may be harder to increase exports if people are consuming domestically more of what is being produced

If the government is worried about the balance of payments and decides to tackle it by deliberately reducing the level of demand, we would automatically see higher levels of unemployment.

Measures to improve local employment versus resource allocation and growth

When a government influences a foreign investor to come to the country and, say, build a factory at Merseyside in the UK, this will provide more jobs (which the government is likely to publicise in triumph) However, if this means the investment is being placed in an area where it is not the most likely to succeed and is not where the company would

naturally choose to invest then resources are not allocated in the best way As a result, economic growth will probably be slower as will the future average standard of living although those now in work at Merseyside will of course be better off It’s a trade-off

Economic growth versus the balance of payments

Achieving high levels of economic growth automatically sucks in imports and worsens the current account on the balance of payments Any action taken to improve growth

naturally worsens the balance of payments The imports consist of consumer goods for the increasing levels of income and the newly employed, as well as raw materials and capital goods to fuel the growth

A higher standard of living versus the balance of payments

As the people of a country grow richer they tend to alter their pattern of demand away from basic survival items, such as simple food, clothing and shelter, towards luxury

imported goods and services, such as posh motor cars and foreign holidays The increase in imports then worsens the current account of the balance of payments

Economic growth, or the balance of payments, versus the value of the currency

Pursuing growth can affect the value of the currency The most likely outcome of a higher rate of growth would be to strengthen the value of the currency, as foreigners appreciate that growth is good for the country However, as the growth will probably be accompanied

by a worsening balance of payments, this can frighten some foreign investors who may ditch the currency—and these currency sales then lower the value of the currency People abroad make their own assessment and act accordingly Their expectations of the future

of the country and its currency play a major role

If the balance of payments worsens for reasons other than successful economic growth, this tends to lower the value of the currency immediately it is observed or even if it is expected and feared

Taking care of the environment versus resource allocation, the distribution of income, the standard of living, and inflation

Taking action to help protect the environment can have many effects As an example, if the act involves raising taxes on fuel to reduce vehicle emissions and hopefully reduce global warming this would alter the allocation of resources—some would argue for the better, others for the worse It would also affect the existing pattern of income

distribution; reduce the standard of living of motor car drivers immediately and increase the cost of transporting all goods; and this would push up prices generally This of course violates the anti-inflation goal

Improved resource allocation versus many other goals

Resources can be altered in a variety of ways, so that generalizations are difficult for who gains and who loses depends on how resources are altered If incomes in rich countries were to be made very much more equal it would improve the standard of living of many (but by a tiny amount each), while worsening it for the few very rich (but by a lot more

each) This would mean fewer luxury items like Porsche motorcars or Patek Philippe watches being demanded.

In general, improved resource allocation is usually good for long term growth and future higher living standards overall

Conclusion

Given all the above difficulties of achieving what we want and reaching most of the more important economic goals, the biggest wonder is that the authorities ever get it even remotely right and yet they do! Those guys do their best and really are good, especially when one imagines that they need to know economics, mathematics, statistics, a bit of psychology and, most important of all, have an awful lot of luck

~~~

Chapter 4 Business Cycles, Recessions and Economic Booms

What are business cycles?

They are periodic swings in production when we see national income rising and falling rhythmically over time They may last for months, quarters of the year, or even years The event is variously called the business cycle, the economic cycle or perhaps regular

Generally we draw the above diagram sloping slightly upwards, to reflect long term

economic growth

What might we expect to see?

In the upswing, prices and profits rise fast, but wages tend to lag In a downswing, profits fall rapidly; wages still lag behind events and so by contrast they continue to increase for

a short time before levelling off or even eventually falling

Between 1992 and 2008 Britain was in a continuous upswing—a very long time and indeed

it seems to have been the longest period of economic expansion on record Then in 2008

came the financial crisis or the credit crunch, and the real economy turned down This was a global event so the UK was not alone in this.

When did the business cycle first appear?

The cycle seems to have appeared about the mid Eighteenth Century, as the first

industrial economies began to develop; by the mid Nineteenth Century the business cycle was clearly in place and recognised

During the long expansion for much of the 1990s and up to 2008, some asked if the

business cycle had ended and the then Chancellor of the Exchequer, Gordon Brown (later

to become Prime Minister) said it had ceased to be and there would be no more boom and bust He was of course completely wrong It is possible, however, that business cycles may become a little less common in the long term Perhaps information technology and rapid restructuring is making it easier to head them off? Against this, the increases speed of communication and economic transmission belts may make it harder We simply do not know yet

Why are cycles important? There are many reasons

1 In a slump, we lose output that we could have had; unemployment rises, the newly unemployed are worse off and suffer a lower standard of living; school leavers find it hard

to get a meaningful job; and people face increasing uncertainty and worries Crime rates may also rise

2 When output turns down it means that the average long term growth rate is lower—and

so is the standard of living

3 The more extreme lunacies of a boom may distort resource allocation, e.g., too much went into dotcom and hi tech companies in the late 1990s

4 Slumps may lead to a distortion in resource allocation if the government decides to protect a few groups that it favours, e.g., banks, motorcar manufacturers or farmers, and subsidise them or bail them out

5 The cycle interferes with government budgets In a boom, government revenue rises from items such as income tax, company tax, and VAT (a form of sales tax) which all increase At the same time, because the level of employment is increasing, government expenditure on welfare payments and social security falls With both increased revenue and reduced expenditure, the government surplus expands

The reverse happens in a slump: revenue falls and welfare expenses increase, so a deficit emerges (or increases should one already exist) The government may have to borrow to cover the deficit—which can interfere with other government targets like the Public Sector Net Borrowing requirement In the UK, in 2009 government debt increased sharply and it became a major headache for the future The government policy is, or rather used to be,

to balance its budget over the cycle but it has significantly failed to do so

6 If the government reduces the rate of interest to try to increase the level of aggregate demand, which is likely, then borrowers gain, savers lose, and individual mortgage

repayments fall In other words, there is a redistribution of income

7 If there is an extended recession or a depression, prices may actually fall, in which case pensioners and other fixed income groups see some gain as their living standards rise Pensioners on balance still tend to lose as many of them rely on interest earned on savings

to supplement their income—and interest rates are likely to be low Similarly, those

pensioners wishing to purchase an annuity (a guaranteed income for the rest of their life bought with a large lump sum upfront) find that low interest rates mean a much smaller

annuity income and a worse end-of-life experience than they had anticipated They are more likely to out with a whimper than a bang.

8 In a slump, firms may put off investing which can prolong the slump and perhaps lead to

a full recession This lower investment is also likely to lead to slower growth in the future

9 If we could only better predict the timing of the peaks and troughs the government could improve the timing of its interventions and smooth out the cycle to some extent

Why do cycles occur?

This is the big question! There are lots of different explanations, but certainty certainly eludes us Someone once said "There are two kinds of business cycle forecasters: those who do not know, and those who know that they do not know!" And that is about right

1 The Classical School

Here it was felt that long term recessions were not possible, for if production was

occurring it meant that people were working and thus had incomes; they spend the money

to buy goods and in this way supply creates its own demand (Say’s Law) Keynes claimed that the Classical School had no theory of cycles and they just felt that cycles were an aberration which time would solve automatically, which is to say that the system was self-correcting The Classical School felt that in a slump, prices would fall and would continue

to do so until they wiped out the lack of demand and the economy would start up again Prices and wages should go up and down in a cycle, rather than production doing so Since

we actually see real output going up and down instead, the problem must be sticky wages and prices It has to be some problem in the system that prevents prices and wages from falling in a slump and it is this that should be tackled

2 Karl Marx

He claimed that the nature of the capitalist system is to produce very efficiently because costs are always being squeezed; output increases rapidly under capitalism but people do not spend all their income so that ultimately demand will be less than supply In the end there must be a downturn as supply outruns demand and the result is that there will be business cycles Over time the downturns will get bigger until the people have had enough

—then there will be a political revolution and capitalism will collapse A function of the Communist Party is to hasten this event

3 J.M Keynes (and others who pushed the analysis further)

Aggregate demand can be deficient—contrary to the claims of Say's Law, supply does not

create its own demand Workers do not spend all their money but save a proportion To

combat deficient demand the government can increase aggregate demand via fiscal and monetary policies which will wipe out unemployment and in this way prevent a major depression Without such government intervention, wages will be sticky in the downward direction and neither wages nor prices will fall far enough to wipe out unemployment.The liquidity trap, in which interest rates cannot fall enough to stimulate investment, can prevent the successful working of monetary policy; we saw this in Japan after 1991 and well into the Twenty-First Century, when interest rates were effectively zero but the Japanese economy continued to stagnate According to Keynes, fiscal policy and direct government spending has to be the answer when this happens

4 The stock (inventory) cycle explanation of the business cycle

It is the way of the world that as firms sell they run down their stocks then have to

reorder In any one industry, firms tend to do this about the same time, for they all face the same market conditions If all firms suddenly order large amounts it kicks off an

upswing but when they stop it causes a downswing These stock cycles may last for three

to five years