ES10002 (at least that is the number this month!!) Introductory Macroeconomics

Lecturer           John Hudson, email

Organisation         2 x 1 hour lectures per week

                                10 x 1 classes per semester (ALL students)

Assessment           60% end of semester examination

                                20% for each of two essays for class tutors

Reading                 R.A.Lipsey and A. Chrystal Principals of Economics (ninth edition)

                                Griffiths and S. Wall (eds) Applied Economics

                                Begg Fischer and Dornbusch

                                A series of handouts in the Short Loan section of the Library




 Web Sites:

HM Treasury in London: and also

General economics web site:

Economist Website:

American Economics Association (with lots of resources)

Bank of England:

And for video clips

Several video clips relevant here, including the ones on inflation and also the one on what the Bank of England does

Also of passing interest:

For recent data on the whole of the UK economy:

The New Palgrave Dictionary of Economics, described as the world's most extensive and authoritative economics reference resource. The New Palgrave Dictionary of Economics, 2nd edition, edited by Steven N. Durlauf and Lawrence E. Blume, contains over 1,850 articles by more than 1,500 of the world's leading economists.      

See also these data sources:

Also see IFS later


Material Specific use of Winecon will not be done in the lectures or classes. But students can make appropriate use of it on their own initiative. Students will, however, make constant use of the IFS’s Virtual Economy. Amongst other things this includes a macroeconomic model of the UK economy. But it contains much else besides. An early visit to this Web site is most strongly recommended Also recommended is that you subscribe to either the Economic Journal (EJ) or the American Economic Review (AER). As students you qualify at a reduced rate, about £22.50 for the EJ. It is not that much more for the AER, and you get the Journal of Economic Perspectives and the Journal of Economic Literature, both of which are particularly good and particularly useful for students, thrown in. You may need a lecturer to counter sign your application. Have a look at the journals in the Library. In any case these are the journals you should go to for additional material to supplement the lectures throughout your 3/4 years at Bath. To get a good degree you need to be able to give back in exams, etc, material which the lecturer did not give to you as well as demonstrating a complete grasp of what he/she did give you. Finally, as economists, you should refer regularly to the Economist and even more importantly the FT. The Weekend FT, simply as a newspaper, is one of the best buys around.



L+C:                       Lipsey and Chrystal

VE          Virtual Economy on the Institute for Fiscal Studies Website:

 And choose virtual economy option on the left, alternatively:

HMT: HM Treasury in London:

GE: General economics web site:


See also:

Essay on US Trade deficit and trade deficits in general:

Course Outline

  1. Introduction to Macroeconomics L+C Ch. 20
  2. Circular Flow of Income and Expenditure L+C Ch.20
  3. National Income accounts RP
  4. The Consumption Function and the multiplier L+C Ch. 21
  5. For above:
  6. The Investment Function and the accelerator L+C Ch. 21
  7. The money supply and money institutions L+C Ch. 25 and Ch 26
  8. Output determination in a closed economy, aggregate expenditure, the IS-LM model Ch. 26 L+C
  9. Exports and imports and the balance of payments L+C Ch 28
  10. Exchange rates, purchasing power parity, The Purchasing Power Parity debate, Alan Taylor & Mark Taylor, Journal of Economic Perspectives, Vol. 18, Fall 2004
  11. Unemployment Ch. 3, Hudson (1)
  12. Inflation L+C, Ch 30 Hudson(2)
  13. The Keynesian approach to policy making and the life of John Maynard Keynes, VE, RP, GE
  14. The monetarist approach to policy making and the life of Milton Friedman, VE, RP, GE
  15. The balance of payments and exchange rates L+C Ch. 28
  16. Macroeconomic Modelling, Hudson(3), HMT
  17. Economic growth and economic cycles: The Kondratief and the life of Joseph Schumpeter. L+C Ch. 27 RP, GE
  18. The impact of bankruptcies on the macroeconomy. Chapter 11 of the US Bankruptcy Code, Hudson(4) and Hudson(5).
  20.  The Impact of Aid on Growth and Poverty – Papers in Economic Journal Symposium, June 2004, particularly Collier and Dollar, see too:                            
  21. The Determinants of Productivity – Notes to be added to course.


NOTE: Two links for TV recordings of lectures. These will not be given ‘live’. BUT do form part of the course and may be examined on as with any other topic. The first is on modelling the second unemployment. POLICY.ppt

For a video on Keynes see:


ESSAY Number ONE: Deadline: monday 12 March MIDDAY (i.e. 12 noon is the deadline). NOW: Back up your laptop on a flash drive, in particular keep copies of all your essays and important work. Losing work because of laptop failure will not be acceptable as an excuse for late work.

What has been happening to consumers expenditure in the EU in recent years and why? Conclude by forecasting what will happen in the period till the end of 2016.

Word Limit 1500 Words; people say what does this mean, is 1600 words OK? NO. 1500 words, is the limit, 1501 words is over the limit. This excludes the title, figures/diagrams, tables and references. But includes footnotes. What is recent? What does the EU mean? That is up to you to decide. But a silly choice will lose marks

With this first essay (but not the second) you will get back a mark sheet relating to the following: 

·          Essay style, including appropriate use of paragraphs, sentences (not too short and not too long and not continually beginning with the same word(s)), spelling, etc. A good structure should contain an introductory paragraph outlining what you will do and defining anything that needs to be defined. In subsequent paragraphs you should deal with a point or a point of view, finish and then move onto the next.  (20%)


·          Your grasp of the economics. (40%)


·          Originality and breadth of the literature referenced. You should cover all the relevant material AND perhaps give references that were not given to you. But beware not all journals are of equal stature nor are all articles. Also too look at the IMF, World Bank, OECD and Central Bank websites.  (20%)


·          The ‘feel’ of an essay. When you see a film or play you like, or a piece of music, or a book, you know that it is impossible to totally define in words why you like it. Yes it was exciting, well acted, well played, etc. But at the end of the day there is something which distinguishes a good piece of work from a poor one which it is impossible to pin down. So it is with essays. We cannot give you a cookbook of recipes which constitute a ‘good economist’, or rather the cook book will only take you so far. (20%)


ESSAY Number TWO: Deadline Monday April 23, MIDDAY. (i.e. 12 noon. This topic is dependent on the program being available at the time of the project). If this is not available by the evening of Friday 9 days before deadline then go to (for an alternative coursework):. COURSE WORK.doc


 Back up your laptop on a flash drive, in particular keep copies of all your essays and important work. Losing work because of laptop failure will not be acceptable as an excuse for late work.

The student is to log into the IFS Website (see the website at the beginning of these notes with other web references) and run their Virtual Economy model of the economy. I will give you the following specific changes to make. These will be different for different students (the foruma for this is given below).

  1. Change the basic rate of Direct Taxation by x1 (e.g. 22 to 26)
  2. Change Indirect Taxation by x2 (VAT)
  3. Change Government expenditure by x3 (e.g. both government capital spending and government current spending), i.e. all of:

Government Spending

Help on Government Spending

National Health Service


Law and order


To calculate x1-x3 take your date of birth: e.g. 29.06.83 (29 June, 1983)

For x1 subtract second number from first (2-9 =-7). If in excess of 5 in absolute value then divide by 2 and if necessary round up) -7 is in excess so divide by 2 = -3.5 and round up to -4. [Note a negative increase is in fact a decrease]. This is then x1. Repeat for x2 with third and fourth digits, =0-6=-6, divide by 2=-3 no need to round up hence x2=-3. For x3 use final two digits: 8-3=5, No need to divide by 2 hence x3=5. If any number is zero you may raise it to 1%. The above does leave latitude for you to make certain decisions (e.g. what exactly is direct taxation). This is part of the project and you are to defend those decisions and the marks will in part depend upon the assumptions you make. If you are to change interest rates then you should divide your number by 4.

You are to report the impact of the above on (i) inflation, (ii) unemployment and (iii) the balance of payments. This will be the case for each of the above on their own and for all three combined. You are then to comment, i.e. explain, these changes.

 Word Limit 1500 Words. THIS MEANS 1500 words.



Attendance at classes is compulsory. failure to attend either two classes in succession or more than two classes in total will result in your being reported to the Director of Studies and possibly to the university authorities. Your tutor has total flexibility to arrange the classes as he/she feels is best. The suggested format is that the tutor should assign to 4/5 members of the tutorial group the specific task of presenting the class topic to the rest of the group. The main exception to this is the macro-economic modelling exercise, where all students should bring their results. But again the tutor has total flexibility to design the classes as they wish. The following is only a suggested list of topics.

1. The main factors affecting the marginal propensity to consume in the UK are. The students should present graphs showing how the marginal propensity to consume has varied over time since 1970, compared with one other country which you are to choose at random. All students should do this prior to the first class. That is they should download the Excel file above. Plot consumption again GDP, this gives the apc and by definition the share of consumption in GDP. What has been happening to it? Is it good? Now calculate the change in GDP and the change in consumers expenditure from one year to the next. Plot the two together. The slope of the line (with the change in consumption on the Y axis) gives us the mpc..

2. Assuming purchasing power parity, take the exchange rate of the US$ against the pound sterling in 1980 then calculate what the exchange rate would have been, with 1970 as the base year, had purchasing power parity prevailed. That is you should calculate: Noute PUS (the consumer price index in the US is included in the data set.

ER* = ER(1970)*PUS/PUK

where ER is the exchange rate of £ into $, currently about 1.60, PUK is the consumer price index in the UK, PUS is the consumer price index in the US. Discuss the graphs that you get and the reasons for the divergence between ER* and the exchange rate that actually happened.

3. Plot the Phillips curve since 1970, i.e. the inflation rate on the vertical axis against the unemployment rate (in % terms) on the horizontal axis. Now assume that expected inflation in one year (e.g. 1990) equals actual inflation in the previous year (e.g. 1989) calculate the change in the inflation rates and plot against the unemployment rate and comment. Plot the unemployment rate in the UK against the unemployment rate in the US during the period 1970-1998 and explain the differences.


4. The student is to log into the IFS Website and run their Virtual Economy model of the economy.

  1. Increase Direct Taxation by 2 percentage points
  2. reduce the rate of interest by 1 percentage point
  3. Reduce Government spending by 3%


Summarise the impact upon the economy and rationalise these changes using the theory you have learnt during the course of the lectures.


5. The final classes might well be taken up by preparation for the exam.

Studying at University is about working hard, not just accepting what you are taught, but reasoning it out for yourself and deciding whether you accept it or not. As first years that is a tall order, but as you progress through your degree this should characterise your learning more and more. Do not misunderstand, you are not to reject everything, and when you do you reject a theory you should be  cautious. Most times no one theory is totally right, nor indeed totally wrong. It is shades of grey rather than black and white. Studying at a top University demands even more.

What you get out of it depends on what you put into it and what others around you put into it. The value of your degree also depends upon the reputation of Bath and Economics at Bath and in part too that is in your hands. When you graduate you will impress, when you go on placement you will impress. This is because you will have worked harder than others, been subject to more demands. At another, lesser, University you might get stuck on something and ask your lecturer how to do it and they will tell you. If you were to ask me in say final year econometrics, I would tell you to go away and work it out yourself. Then when you graduate you will be able to solve problems yourselves, whilst the students from other lesser universities will be looking round for someone to ask? Wont be there. In addition of course what I teach is always at a level which is a notch higher than the lesser universities. So work with us to continue to make economics at Bath the best and take pride in it and yourself..

But take time too to explore the region, Britain is not just London, Bristol and Bath. For instance one of the most atmospheric places I know is Tintern Abbey, slightly difficult to get to, but worth the trouble, then there are the Brecon Beacons, Wells, Cheddar, the Somerset coastline and of course St. Andrews.

Macroeconomics Lectures: First Years

These notes are a guide to the course. They are no substitute for reading the references nor attending the lectures, where more will be covered.

Macroeconomics Lectures: First Years

1. Introduction to macroeconomics; the circular flow of income, GDP tables, the difference between nominal and real variables. Log on to:


The national income identity:

Y = C + I + G + X – M                                                                                  (1.1)


C=Consumers’ expenditure


G=Government spending



For discussion on measuring GDP See:

Test yourself:

For circular flow of income:

2 Consumers’ expenditure. Let us set up a simple model

C = a + bYD                                                                                                                                          (2.1)

YD=personal disposable income = (1-t)Y                                                                                       (2.2)

Where a = autonomous consumption, b = the marginal propensity to consume, t = the tax rate, (1-t) = the proportion of every pound earned retained as income after taxes. The average propensity to consume equals C/YD = (a +bYD)/YD = a/YD + b. The marginal propensity to consume represents the change in consumption (D C), following a change in disposable income (D Y). It is D C/D Y and in the above equation equals b. This is an example of the simple Keynesian consumption function (after the economist John Maynard Keynes). An example of Keynesian economic policy would be when the government wished to increase Y by increasing C. It could do this by cutting t, increasing YD.

Alternatives to the Keynesian consumption function are provided by Milton Friedman’s permanent income hypothesis and Ando and Modigliani’s life cycle hypothesis. The former postulates that consumption can be modelled such:

Ct = a + bYDpt                                                                                                                                       (2.3)

Where YDP is ‘permanent income’. In practice Friedman proxied permanent income by a weighted moving average of past incomes:

YDpt = g 0YDt + g 1YDt-1 + g 2YDt-2 + g 3YDt-3 +……………..                                                           (2.4)

where g 0 > g 1 > g 2 >……………. In practice, however we do not estimate:

Ct = a + b(g 0YDt + g 1YDt-1 + g 2YDt-2 + g 3YDt-3 +……………..)                                   (2.5)

But Ct = b 0 + b 1YDt + b 2Ct-1                                                                                                             (2.6)

(Note: t denotes the time period, t is current time period, t-1 previous one and so on. The use of b ’s in an equation like (2.6) is standard in economics. Comparing (2.5) and (2.6) we can see that a= b 0.) In equation (2.5) the bigger the influence of the past, the bigger will be g 1, g 2,.. etc in relation to g 0. In equation the influence of the past is picked up by b 2. The closer this is to 1.0 (its upper bound), the greater the influence of past consumption on present. In terms of Keynesian economic policy, a cut in taxes which increases YDt will have a much more muted impact on C in (2.6) than in (2.1). Friedman’s whole career has been spent on trying, with considerable success, to prove that Keynesian economic policy is (i) harmful and (ii) ineffective in controlling Y.

Question: in equation (2.6) what is the short and the long run marginal propensities to consume (mpc)?

The consumption function is one of the most researched concepts in economics and still the research goes on. To(2.6) we might consider adding (i) the real rate of interest (rt) and (ii) the rate of inflation (D Pt, generally denoted by P with a dot over it):

Ct = b 0 + b 1YDt + b 2Ct-1 + b3D Pt + b 4rt                                                                                             (2.7)

The impact of the rate of interest is obvious, it represents the returns to savings. If people respond to these returns (i.e. they are ‘incentive savers’) then a higher rate of interest will increase savings and thus reduce consumers expenditure (b 4<0). But there are alternative possibilities. They may be ‘target savers’, saving for a specific amount (£1000 for a holiday) an increase in the rate of interest will allow them to reach their target more easily, hence they need save less and consume more (b 4 >0). The impact of inflation was first suggested by Angus Deaton - then at Bristol. He showed that empirically the evidence is strong that an increase in inflation tends to reduce consumers expenditure (b 3 <0), but he failed to provide a satisfactory explanation as to why this should be so. Probably the best explanation is that inflation tends to erode people’s wealth (or at least that which does not increase with inflation) to restore this to its desired level people save more and spend less.

3. Investment Expenditure

One can distinguish between

inventory investment (investment in inventories or stocks of finished goods and raw materials),

residential investment (investment in housing, i.e. new housing), and

business investment or gross fixed capital formation (includes public sector investment, roads, hospitals, and machines).

In general we will be focusing on the latter, unless specified otherwise. The main factors influencing I will include the real rate of interest [r] and Expected future retained (i.e. net of company taxation) profits. The real rate of interest is (using the Fisher equation) equal to nominal interest rates (n) less expected inflation (D pe):

rt = nt - D pet                                                                                                                                                                                                                 (3.1)

In fact it is standard to denote inflation with a dot (· ) above the p, but it is simpler to type D p. The use of the superscript to denoted expectations is standard.

Expected profits net of taxation indicate the potential importance of company taxation in determining investment. Taxes apart profits will depend upon how well the economy is doing and how well it is expected to do. How to model such expectations? One possibility – similar to the permanent income hypothesis is that we model expected profits (P e) as a weighted moving average of past profits:

P et = g 0P t + g 1P t-1 + g 2P t-2 + g 3P t-3 +……………..                                                                          (3.2)

Hence (again similar to when we wanted to model lags in the consumption function) we can use the following equation:

It = b 0 + b 1P t + b 2rt + b 3It-1                                                                                                                                (3.3)


The lags involved in investment can be very long indeed, investment projects take a lot of planning, etc and it may be two years or longer before a change in interest rates has its full impact on investment. One version of the investment function which bypasses the link between profits and GDP is the accelerator model. The naïve accelerator is:

It = g (Yt – Yt-1)                                                                                                                                                      (3.4)

Where g is the capital-output ratio. A slightly more sophisticated version is:

It = b 0 + b1(Yt – Yt-1) + b 2rt + b 3It-1                                                                                                    (3.5)


4. Exports depend upon World output (WD, non-standard terminology) as a proxy for output in key markets and the competitiveness (COMP, not standard terminology) of British (to be parochial) goods. The latter is determined by the exchange rate and prices in Britain and prices in the rest of the world. Let us be a bit more specific and suppose we are dealing with the competitiveness of British viz and viz American goods. The COMP equals:

COMP = ER(PH/PUS)                                                                                                                            (4.1)

Sometimes this is called the real effective exchange rate. For example ERxPH is the price of a British car in US dollars. E.g. car = £10,000, exchange rate $1.60 = £1, then price in US dollars of car = $16,000. If the SAME quality of car retails for $20,000 in the US then COMP = 16,000/20,000 = 0.8 and indicates that the UK is competitive. This definition of COMP sees high values as being less competitive.

Hence the demand function for British exports is:

ln(Xt) = b 0 + b 1ln(ERPH/PUS)t + b 2ln(WDt) + b 3ln(Xt-1)                                                 (4.2)

ln stands for log (to the base e). Why logs?? Because when we use logs on both sides of the equation the coefficients are elasticities. Hence b 2 is the elasticity of British exports to World demand. Or rather it is the short-run elasticity because of the presence of b 3ln(Xt-1). Why include this variable? Same reason as always, it proxies lags in behaviour. Clearly, for example if we devalue the currency to boost exports, the full impact will not be felt immediately, Most obviously orders will have already been placed on the basis of yesterday’s exchange rates.


5. Imports and the balance of trade


See US balance of trade figures: and

The equation for imports is likely to be similar to that for exports and it will follow the same logic. Basically,

ln(Mt) = b 0 + b 1ln(ERPH/PUS)t + b 2ln(Yt) + b 3ln(Mt-1)                                                   (5.1)

where we have replaced WD with Y. That is the demand for British imports will increase with GDP. Remember one interpretation of Y is as the total amount spent in an economy. Clearly, the more that is spent, then other things being equal, the more will be spent on imported goods. b 1 now represents the ‘price’ elasticity of British imports.

The balance of trade is the difference between exports and imports (X-M). It is in surplus when X>M and in deficit when X<M. A trade deficit can be financed by (one way or another) ‘borrowing’ money from abroad. This may be explicit as for example borrowing from the IMF or on the World capital markets. Or it might be implicit when firms borrow on the world capital markets (where they may be able to obtain cheaper loans than in the UK) or when a foreign firm invests in the UK (e.g. when Honda build a car plant using money raised in Japan. A balance of trade deficit is not always a worrying development. If the country is restructuring its industrial base by a significant investment program. Then a trade deficit is likely to be the case in the short-run, but when the investment program is finished may well be replaced by a trade surplus. Neither are trade surpluses necessarily a good thing. The Japanese economy has a massive trade surplus for many years, but since the early 1990s its economy has continually been in the doldrums.

Nonetheless if a government wishes to improve its trade balance, one way is to devalue the currency. The impact on the trade balance will be represented by the J curve (see the text book). Britain will sell more cars, etc abroad and import less wine because devaluation has made foreign goods more expensive and British goods cheaper. But equations (5.1) and (4.2) show that the impact is not immediate but subject to lags. However, as soon as we devalue we get LESS for each car we sell abroad and pay MORE for each bottle of wine. Hence the day after devaluation, the trade deficit WORSENS. But over time as we sell MORE cars and import LESS wine, so the trade balance will improve. Will the impact of devaluation always be to improve the trade balance? Not necessarily. On the export side we sell more cars, but get less for each one. It depends which changes most as to whether we actually earn more money from our exports. This condition is known as the Marshall-Lerner condition (see text Book) and

Named after English political economist Alfred Marshall (1842-1924) and Romanian-born economist Abba Lerner (1905-1982), Marshall-Lerner principle states the conditions under which a change in a country's exchange rate will improve its balance of payments.

See The Big Mac index:

6. The Money Supply and Monetary Institutions and the LM Curve   and

If you were to ask the typical man in the street what he thought the money supply was then he would probably respond that it was the amount of notes and coins in circulation. But if you were to ask him what he thought the definition of money was he might respond that it is used to buy things with – in economics jargon, a medium of exchange. But this presents a problem with the earlier definition for I can buy things with my cheque book and also with my credit card. In fact money is defined as having the following purposes:

It acts as a medium of exchange

It serves as a store of value, that is you need not spend on something today, but delay that expenditure to tomorrow, or next month. You keep your ‘money’ until you need it.

It serves as a unit of account. A pint of beer costs £1.80. When you go to the bar and ask the price that is what they will say. They will not say, two loaves of bread or one tenth of an economic lecture.

In all of these aspects money makes life easier for firms, consumers and governments. When I want a pint of beer, I do not have to find a publican who wants economics lectures and agree with him a rate of exchange (an example of a BARTER economy). The government pays me in money, which I can then use in any inn in the country.

Now it should be obvious that there can be no one measure of money and the following summarises some of the definitions we use:

UK Money Supply: Feb 1998 £ million

Notes and coins outside Bank of England                     25,891

Bankers’ deposits at BoE                                                  180

M0                                                                                          26,071

Notes and coins with public                                               21,648

Non-interest bearing bank deposits                                  34,295

Other retail bank deposits                                                  331,783

Building society retail shares and deposits                     96,747 

M2 (now referred to as retail M4)                                    484,473

Wholesale bank deposits + CDs                                       234,660

Wholesale building society deposits + Cds                     6,868

M4                                                                                          726,001

M3H                                                                                      848,277

M3H is a new harmonised measure created to have standard money definitions throughout the EU. It is equal to M4 plus residents’ foreign currency deposits in UK banks and building societies plus public corporations sterling and foreign currency deposits in UK banks and building societies.

Note: CDs sterling certificate of deposits.

However, as the Wikipedia website emphasises the statistics have changed and now the Bank of England emphasises M0 and M4. But the others can still be calculated.

Chapter 25 in L+C provides an excellent summary of all this. The important point to note is that the BoE can control the amount of notes and coins in circulation. But has a degree more difficulty in controlling other types of money. Thus a high street bank can lend £1,000 to one of its customers who adds it to her current account thus increasing M2. However the extent to which the Banks can do this is limited by certain ‘ratios’ e.g. the amount banks can lend in this way cannot exceed (has an upper bound) some multiple of its cash + deposits with the BoE. hence if the BoE increases M0 by 10% it gives greater freedom for M4 to increase. But this is not an exact science. Also turn to Table 6.2 etc for more details on money supply  and still more from the Bank of ENGLAND: and for some definitions see:

The end of cash?????? SEE:

We now turn to why people demand money. The following is basically Keynes’ approach as specified in the General Theory (the book he published in 1936)

Transactions motive People desire money to finance their expenditures or transactions varies with Y The greater is Y the greater will be the number of transactions and the greater the demand for money.

Precautionary motive: these provide a cushion against the uncertainty of life and when and where you will be called upon to pay cash. varies (with R?)

Speculative demand. People keep money aside for ‘a good thing’. varies with R. (the nominal rate of interest)

The argument for the above two is simple (and also a little simplified). If people keep money back for speculative or precautionary purposes then they do not receive the ‘interest’ they could get if they invested it (this is less true know than in 1936 when Keynes formulated the theory, now you can get interest on money you keep in a current account. Arguably the real cost is the difference between the current account and the deposit account rate of interest as in (6.2) below, lets ignore this for the time being)

Hence the demand for money will be a log-linear function like:

ln(MDt) = b 0 + b 1ln(Yt) + b 2Rt + b 3ln(MDt-1)                                                                 (6.1)

In the BoE model of the economy we have the following long-run equation:

ln(MD) = ln(Y) + 0.02(RD - RS) +0.78ln(NFW/Y)                                                                         (6.2)

where RD-RS = deposit rate - London clearing bank’s base rate.

Turning back to (6.1). This represents the demand for money. Equilibrium in the money market will exist when money demand equals the money supply. As we saw earlier we can assume, with some inaccuracy perhaps, that the Central Bank (the BoE in the UK) can control the money supply. Let us suppose it sets it at MS1. We will work with a simpler version of (6.1) without lags, equilibrium will then require:

ln(MS1) = ln(MD) = b 0 + b 1ln(Y) + b 2R                                                                                                (6.3)

Rearranging to get (6.1) on the eft hand side we can see that this becomes:

ln(MS1) - b 0 - b 1ln(Y) = b 2R                                                                                                      

or ln(MS1)/b 2 - b 0/b 2 - b 1/ b 2ln(Y) = R                                                                                            (6.4)

This says that given a fixed money supply and given a specific value for Y there will be a unique value of R which secures equilibrium in the money markets. This relationship in (6.4) which specifies the combinations of R and Y which secure equilibrium in the money markets is known as the LM curve. Intuitively we have

Key paragraph; I know the above is not easy, if you cannot understand the above algebra, you must understand the following argument. Y1 ® TD1 ; R1 ® SD1 If we have equilibrium in the money market then TD1 + SD1 = MS1. Right now what happens if Y increases to Y2? Y2 ® TD2 (where TD2 > TD1). Hence with a fixed money supply in order to retain equilibrium in the money market SD will have to fall which will require a higher rate of interest. Equilibrium in the money market means that with a higher level of GDP we must have a higher level of R. We will derive the LM curve diagrammatically. But note the following. The LM curve slopes upwards. An increase in the money supply means that for a given level of interest rate and hence a fixed speculative demand, there will be more for transactions purposes and the new equilibrium will require an increase in Y. Diagrammatically the LM curve shifts to the right with an increase in the money supply. Note: TD, transactions demand, SD speculative demand. We have assumed precautionary demand does not vary with R. R= rate of interest (nominal) and Y=GDP.

7. The IS Curve

We have covered equilibrium in the money markets. We now turn to equilibrium in the real side of the market - the goods market. We have stressed before that we can measure GDP by counting up how much people spend or by counting up their income, the two are the same. Total income = Total expenditure = Total output. Let us concentrate on total income in a closed economy (no imports or exports). People do three things with their incomes: they spend it, they pay direct taxes with it or they save it:

Y = C + S + T                                                                                                                                        (7.1)

But we have already seen, and indeed it has been the basis of our analysis, that on the expenditure side, there are in a closed economy three sources of expenditure:

Y = C + I + G                                                                                                                                        (7.2)

Now lets simplify things still further. Let us assume a balanced budget (T=G). It does not take a genius to see that all of this implies that:

I +G = S +T                                                                                                                                           (7.3)

We have done nothing startling so far and indeed (7.3) can hardly be a condition for equilibrium. It is a truism, it is true by definition. But this alone should give you cause to pause a minute and think. Why should it be that investment which is largely done by firms should equal savings which is primarily done by households? Why should two decisions made by two different sets of people be equal always and all the time? The answer is of course is that we fiddle the figures. Any mars bars left on the shelf at the end of the year which the shop keeper had expected to sell are part of his stocks or inventories and counted as investment. Not an investment she he/she expected to make, not a planned investment but an investment none the less. The same is true for unsold cars, cranes, aeroplanes, etc, etc. The firm who makes steel pipes and sells less than expected engages in unplanned investment. Now it should be obvious that a plausible definition of equilibrium is when everyone’s plans are realised. In this case planned investment equals actual investment (Ip = I) and planned saving equals actual savings (Sp = S) (I have not followed the argument through but it is pretty obvious that in certain cases consumers will not be able to buy what they will have planned in which case there will be unplanned saving). Now when everyone’s plans are realised and (7.3) holds, as it always does, we have the following definition for equilibrium in ‘the goods market’ or ‘the real economy’.

Ip + G= Sp +T                                                                                                                                         (7.4)

We have already analysed what people plan to save, it is the reverse of what they plan to consume. In the simple keynesian function it is a function of disposable income:

Sp = a* + (1-b)YD                                                                                                                                (7.5)

Sp = a* + (1-b)(1-t)Y                                                                                                                            (7.6)

I will not do it here but this derives straight from (2.1) and (2.2) with a* = -a. The key point and it is a pretty obvious one is that planned saving is an increasing function of Y. Nor will I go into this but it Is pretty obvious:

T = tY                                                                                                                                                     (7.7)

Now lets turn to planned investment, our previous analysis suggested that this would be an decreasing function of the rate of interest (R). We are simplifying here. I am not distinguishing between the real and the nominal rate of interest and I am not considering all the other things that may impact on investment.

IP = c + dR                                                                                                                                             (7.8)

remember that because an increase in R causes a fall in IP d will be negative. We will assume G is exogenous, i.e its value is fixed and is therefore outside the scope of the analysis. Right, now using (7.4), (7.6), (7.7) and (7.8), we can see that equilibrium in the goods market requires:

c + dR +G = a* + (1-b)(1-t)Y + tY

Rearranging we have:

dR = a* + (1-b)(1-t)Y - c + tY - G

R = a*/d + (1-b)(1-t)/dY - c/d + t/dY - G/d                                                                                      (7.8)

Now (1-b)(1-t)/d < 0 (because d<0). Hence an increase in the rate of interest will need a lower level of Y to retain equilibrium. Again I am aware that the above argument is a bit convoluted, so lets give it an intuitive spin:

Key paragraph: An increase in interest rates will cause a reduction in planned investment. To maintain equilibrium we must have a reduction in the total of planned savings and taxation. This requires a reduction in Y. The IS curve associates higher interest rates with lower Y.

­ R ® ¯ IP Hence to stay in equilibrium we need ¯ SP which will only come about of Y¯

Just one final note before we do this diagramtically. According to (7.8) what impact will an increase in G have on R? What further impact will this have on I?

We now turn to a diagrammatic derivation and analysis of IS-LM curves.

 For IS & LM  Curves click on following links:


The IS curve shows the locus of points which generate equilibrium in the goods market. Where equilibrium is defined in the case of a closed economy (no exports or imports) as when planned investment + government spending equates to planned savings + direct taxation. (direct taxation = income tax in the main). This is derived algebraically above. Government spending is fixed. An interest rate of R1 results in a level of planned investment such that I + G = A (note I omit the superscript p from Ip, denoting planned investment, for simplicity). The 45 degree line transfers this distance to the savings + taxation axis. (denoted A again). The level of Y which will generate savings + taxation equal to this is Y1. These two points Y1 and R1 lie on the IS curve. Y1 generates savings + taxation which equals the level of I+G resulting from R1. This exercise is repeated with a lower rate of interest such that two new points are generated on the IS curve (R2, Y2). Join these two points together and we have the IS curve.

The student should now answer the questions:

(i) what happens if exogenous government spending increases. Remember G is determined outside the scope of the model. An increase in G results in an upward and parallel shift in the I + G curve. Plot the new IS curve and you should find it shifts outwards to the right.

(ii) What happens if the tax rate increases? Well obviously T (total taxation increases). But S? Well people will be left with less disposable income and hence they will save less. An increase in the tax rate increases T and reduces S. Which effect predominates? An example will illustrate. Let us suppose we have S = a* + (1-b)YD = a* + (1-b)(1-t)Y. Keep things simple set a* = 0. b=0.7, t = 0.4 and Y=£1000.

S = 0.3*0.6*1000 = £180. T = tY = 0.4*1000 = £400; S+T=£580.

Now increase t to 0.5

S = 0.3*0.5*1000 = £150. T = tY = 0.5*1000 = £500; S+T=£650.

The increase in t (the tax rate) has increased taxes by more than it has cut savings. If you think about it for a minute you may perceive its obvious. If not and if you are bewildered by the difficult maths just learn this an increase in t increases S+T. This will swivel the S+T curve downwards. Again draw the new IS curve you will see it has swivelled inwards.

What is the minimum you must know? The IS curve is the combinations of R and Y which results in equality between planned I + G and planned S +T. An increase in G shifts the IS curve outwards. An increase in t swivels it inwards.



The LM curve shows the locus of points which generate equilibrium in the money market. Where equilibrium is defined as when the demand for money equals the supply of money. For simplicity we restrict the demand for money to just two types: transactions demand (depends just on Y) and speculative demand (depends just on R). This is defined diagramatically above. Quadrant IV shows how the speculative demand for money varies with the rate of interest. A rate of interest R1 will generate a speculative demand SD1. The 45 degree line transfers this amount (0-SD1) to the gap between the money supply and TD1). If the money supply is fixed where it is, a speculative demand of SD1 will leave TD1 for transactions purposes. What level of Y will generate such a transactions demand? Y1. Hence these two points Y1 and R1 lie on the LM curve.Y1 generates a transactions demand TD1 and R1 generates a speculative demand such that these just equal the available money supply. This exercise is repeated for two other interest rates. Join all 3 points together and we have the LM curve.

The student should now answer the question:

(i) what happens if the Central Bank (the Bank of England) increases the money supply?. Clue: The 45 degree line shifts outwards. Plot the new LM curve and you should find it shifts outwards to the right but in slightly an unusual manner.

The shape of the LM curve is a result of the way we have drawn the speculative demand for money. It assumes that there is a floor to the interest rate below which interest rates cannot fall and that there is some minimum amount people will keep for speculative purposes (perhaps zero).

What is the minimum you must know? The LM curve is the combinations of R and Y which results in equality between planned the demand for money and the supply. It slopes upwards. An increase in the money supply shifts the LM curve outwards.


Analysing Government Economic Policy Using IS and LM curves:

For Figures referred to on this page click on:

An increase in Government spending shifts the IS curve outwards. There are several possibilities. In Figure 1a we get a substantial increase in Y (GDP) and a small increase in R. What has happened? The increase in G increases Y, this will cause consumers to spend more money increasing C causing Y to increase still further (the multiplier). This increase in Y results in an increase in the transactions demand for money and with a fixed money supply this will leave less for speculative purposes, driving up the rate of interest. (This views the rate of interest as the ‘price of money’ if the demand increases with fixed supply, the price (interest rates) rise. This increase in R will have a negative effect on I, investment will actual fall thus reducing Y slightly from the boost the increase in G and C had given it. We say that some I has been ‘crowded out’ by the increase in G. In Figure 1b, the increase in Y is much smaller and that in R much bigger than hitherto. What has happened? We are further up the LM curve. To get money for transactions purposes with a fixed money supply we need to shift money away from speculative purposes. Yet on this almost vertical section of the LM curve speculative demand is close to its minimum below which it will not fall. To get even a small amount switched out of speculative demand results in a large increase in interest rates. But this causes a reduction in I almost equal to the increase in G. Crowding out is almost 100%.

In Figure 2 a reduction in tax rates also ‘swivels’ the IS curve outwards. In Figure 2a there is a substantial increase in Y and a small increase in R. What has happened? The reduction in the direct tax rates increases disposable income, this increases consumer expenditure increasing Y. Once more the multiplier works to expand this initial increase in Y. This increase in Y results in an increase in the transactions demand for money and with a fixed money supply this will leave less for speculative purposes, driving up the rate of interest. The analysis from here on in is the same as with the increase in G.



In Figure 3a, we have an increase in the money supply shifting the LM curve outwards. There is once more a substantial increase in Y and a reduction in R. What has happened? The increase in the supply of money has reduced the rate of interest which has boosted investment. This has increased Y and consumers have therefore increased their expenditure (the multiplier) thus increasing Y still further. In Figure 3b, the increase in the money supply has had no impact on either interest rates nor Y. Why? Interest rates are already at their floor they cannot fall any lower (the floor is probably about 1%-2% in practice). This is called the ‘liquidity trap.’ It is possible that this is one of the problems facing Japan at this moment. (They have been stuck in recession throughout the 1990s). As always further details on all of this can be found in Lipsey and Chrystal.

The 45 degree line diagram

For Figures referred to on this page click on:

The 2nd analytical format we will use to show output determination is the 45 degree line diagram. This is simpler and less complete than ISLM as it just looks at equilibrium in the goods market without focusing on the money market. It does however have the virtue that it allows us to focus on the workings of the multiplier. Figure 4 shows actual income on the horizontal axis and planned expenditure on the vertical axis. Our consumption function is the standard one we have used all along, b is the marginal propensity to consume, t is the tax rate, hence (1-t)Y is disposable income. Aggregate demand is found by adding to the consumption line I+G. These are assumed to be fixed (exogenous) That is AD = C+I+G. This tells us what for any level of Y (actual income) planned expenditure (Yp=AD) will be. Equilibrium is where planned expenditure = actual total income (remember total income=total output = total expenditure, hence our definition of equilibrium implies planned expenditure = actual expenditure. Right, now the 45 degree line in Figure 4 equates all points on both axes. Hence take an income of Y1. this will result in planned expenditure of Yp1 and because these two meet on the 45 degree line they are equal. Hence a level of I+G as shown will result in equilibrium output of Y1. What happens then if I+G increases, say there is an increase in G to G’? Well if Y stays at Y1 planned expenditure will be Yp3 where Yp3 ¹ Y1. Y1 is no longer an equilibrium level of income. What is? It will be again where the new aggregate demand curve cuts the 45 degree line. This will be at Y2 where once again planned aggregate expenditure equals actual income.


Now notice that the increase in Y (Y2 - Y1 =D Y ) is greater than the increase in G (G2 - G1 = D G). Why? Well as with ISLM, the increase in G increases Y, this will cause consumers to spend more money increasing C causing Y to increase still further (the multiplier). The ratio D Y/D G is called the multiplier. Let us briefly leave our diagramatical analysis and derive it algebraically:

Y=C+I+G (Closed economy (no imports or exports), national income identity)

C = a + bYD

= a + b(1-t)Y

Insert the above into Y and we get:

Y = a + b(1-t)Y + I + G;

Y - b(1-t)Y = a + I + G ; Y(1-b(1-t)) = a + I + G

Y = a/[(1-b(1-t)] + I/[(1-b(1-t)] + G/[(1-b(1-t)]

Any increase in G (or for that matter I) will be multiplied by 1/[(1-b(1-t)]. This is the multiplier. If b equals 0.7 and t=0.4 then 1/[(1-b(1-t)] = 1/[(1-0.7(1-0.4)] = 1/(1-0.42) = 1.72. Thus an increase in G of £1b will increase Y by £1.72b. Note this keynes argued, and all of this on IS-LM is pretty pure Keynesian policy analysis. That not only would an increase in G increase Y by G it would increase it by more than G. How much will this cost the Government? Well we have a tax rate of 0.4 and Y has increased by £1.72b, hence extra taxes raised equal £0.69b. The cost to the Government will therefore have been just £1b - £0.69b = £0.31b. [Although it may be even better than that, if the number of unemployed falls and as a consequence, the amount paid in unemployment benefit were also to fall]. Note too that for this we will have extra roads, school buildings, a better health service, etc. It almost seems like having ones cake and eating it.





Figure 5. Also shows Keynesian economic policy at work. This time a cut in direct tax rates swivels, the consumption function upwards, increasing equilibrium output (Y) from Y1 to Y2. Note again that although the Government has cut taxes, Y will increase and hence the loss to the Treasury in terms of tax revenue will not be as great as might be originally thought.


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Keynes (on the right) with George Bernard Shaw

We now turn to the third and final diagramatic apparatus we shall use to analyse output determination, aggregate supply (AS) and aggregate demand (AD) curves. This is supposed to be the newest of the three methods but the rationale dates back almost to Keynes. The key difference between this and the other two methods is that the price level is allowed to change. Let us first deal with aggregate supply and repeat the rationale found in L+C (pp. 398-9). The Short run aggregate supply (SRAS) curve shows the quantity of output that firms would like to produce and to sell at each price level on the assumption that the prices of all factors of production (inputs) remain constant.. The Long-run aggregate supply curve (LRAS) does the same under the assumption that the prices of all factors of production (inputs) have fully adjusted to any exogenous shifts in the AD curve. We concentrate on the SRAS curve. The rationale I prefer is that with fixed input prices (including wages) each firm will produce output at the level at which marginal revenue equals marginal cost.. Now if the price of the firm’s output increases clearly the marginal revenue for that product will increase. Hence the firm will increase output, declining marginal returns means that as it does so marginal revenue will fall back. At a higher level of output marginal revenue will again equate to marginal cost.. Hence the SRAS curve will be upward sloping, higher prices will induce higher output. Box 23.3 in L+C discuss the slope of the SRAS curve. We have already established that it slopes upwards, the second point emphasised in L+C is that it gets steeper. The reason is simple. Below a certain level of output firms will have unused capacity and hence will be able to expand output quite easily with marginal cost rising only gently if at all. However, beyond this point it becomes increasingly difficult to expand output. Remember we are in the short run, too short too hire new workers buy more machines, hence to increase output we need to turn to overtime working, which becomes increasingly expensive. Hence a large increase in price will be necessary to coax relatively small increases in output. The SRAS curve is shown along with the AD curve in Figure 6.

For a graphical analysis of aggregate supply and demand see;

For Figures referred to on this page click on:

The aggregate demand curve. This is equal to Aggregate expenditure: C+I+G+X-M. let us explore how an increase in the price level impacts upon C, X and M. A change in the price level affects the wealth of assets denominated in money terms in exactly the opposite way to how it affects the wealth of those who issued it. We need to distinguish between ‘inside assets’ and ‘outside assets’. An inside asset is one that is issued by someone in the private sector to someone else in the private sector (e.g. a bank loan). If it loses value, one loses and one gains, but there should be no net change in private sector wealth. Outside assets are issued by some agent outside the private sector (typically government) to someone in the private sector. E.g. a pound coin. Now is the price level falls by 10% this pound coin will buy 10% more than previously, the private sector holder of the pound coin is richer and as a consequence consumers’ expenditure should increase. This argument has been around for many years and originally put forward by Pigou in arguing with keynes on the General Theory as a consequence it is sometimes called the Pigou effect. How about the effect on X and M? Simple really. If the price level falls and prices in Germany (for example) do not fall or fall less than in the UK and if the exchange rate stays the same, then British goods become more competitive we export more and import less. Thus for all of these reasons aggregate expenditure or demand increases as the price level falls (C increases, X increases, M falls). Hence the AD curve slopes down as shown in the diagram.


Where the curves cross we get the equilibrium output and price level. Note the curves can shift for several reasons. Firstly, as with the IS curve an increase in G will shift the AD curve outwards. Also a change in the real exchange rate, say an increase, which makes domestic goods less competitive, will shift the AD inwards. Similarly the AS curve can shift. It tends to do so for two reasons. Firstly, technical progress. This means that the same amount of labour working with the same amount of capital (machines, etc) will produce more this year than last simply because of technical progress, we become more efficient. This will shift the AS curve to the right, as indeed will investment which increases the capital stock. Thus a reduction in the real rate of interest which increases investment may simultaneously shift the AD and the AS curves to the right. However, there has been much made in the recent literature on ‘shocks’ which can shift the curves. For example, in 1974 and 1979 we had the two oil price shocks which raised input prices and thus raised marginal cost shifting the AS curve inwards. Similarly there can be such shocks impacting on the AD curve and as we shall see later a whole theory of ‘the business cycle may be built around shocks and their after-effects.

Aggregate supply and demand curve analysis is more recent than ISLM and the common view is that it is more relevant as it relaxes the assumption that price are fixed. In fact little in it is new. Keynes was aware shortly after he wrote the book of the Pigou effect. The supposed impact on imports and exports of a change in the price level, depends upon the actual exchange rate not adjusting to maintain the exchange rate constant which is problematical. Keynes too was arguing for the use of expansionary fiscal (and also perhaps monetary) policy at times when output was clearly stuck well below its equilibrium level, when there was considerable excess capacity and when we are therefore .on the flat part of the AS curve. There must be considerable doubt as to whether he ever intended it to be used to ‘fine-tune’ the economy. Fine tuning is when the Government changes the tax rate or Government spending or the rate of interest with a view to increase growth by say 1% at a time when output is slightly below its equilibrium level, or vice versa when it is slightly above this level. And yet Keynesian policy has never been used since 1945 in such a way (one can argue that Roosevelt’s new deal was an early application of Keynesian policy although with what success is debatable. Since 1945 it was used in Britain and the USA to ‘fine-tune’ the economy and yet by the 1970s such usage had fell into disrepute. We shall see why later. But note two things (i) Keynes never intended its use thus, it was a tool to get us out of recessions such as in the 1930s and (ii) the period between 1945-70 was pretty successful in economic terms in Western Europe and the USA. There are problems in using Keynesian policy for fine tuning the economy, particularly those involving ‘lags’ and the student should read up on these in L+C (page 418-423).

In addition there is a further problem in that traditionally there have been three main ‘instruments’ of macroeconomic policy. Government expenditure and taxation (which together form the tools of fiscal policy) and the money supply or interest rates (the two are determined simultaneously, set the money supply and you in effect set the interest rate and vice versa). Now compare these three instruments to the accelerator, the steering wheel and the brake when driving a car. It would be difficult indeed for one person to have control of the steering wheel and another the brake and the accelerator and still expect to get to your destination safe and on time. But that in effect is what has happened in many countries including the UK where Central Banks have control over the money supply and interest rates. Until recently in the UK, the Bank of England did what the Chancellor told them to do. Now the monetary policy committee (MPC, a group of mainly economists including the Governor of the Bank of England and the Deputy Governor, Mervyn King) set interest rates. However, the Government in the UK does set the target for the MPC to hit, at the moment 2.5% inflation. Now provided the bank of England and the Treasury have similar models of the economy then the Chancellor must know what his target means in terms of interest rates, so his lack of control over this instrument is perhaps more apparent than real. But why do this anyway? Why give nominal control over interest rates to the Bank? If the Government wanted to hit 2.5% inflation, then they know the way the economy works just as much as the Bank, so why did they need to cede their authority. The answer lies with the way Keynesian policy has been misused by Governments over the years to engineer election victories. Typically about eighteen months prior to an election we would find interest rates being cut, tax rates cut and Government spending increase. The economy would grow faster, unemployment would fall, people would have more money left in their pocket. The Government would put this down to their skill in managing the economy. In reality, the boom would be inappropriate and shortly after the election (because of the lags involved) inflation would start to rise and the balance of trade significantly worsen. With the election safely won, interest rates would be raised, taxes increased and Government spending cut back on to stop the economy ‘overheating’. Keynesian economic policy was being used not so much to ‘fine tune’ the economy, but to win elections. This ‘boom bust’ government engineered cycle was not good for the economy and Britain’s poor post-war record on inflation was compared to Germany’s where the Central Bank had control over monetary policy. Hence Gordon Brown copied the Germans in this because we cannot trust the politicians not to manipulate the economy for their own ends. For details on mpc see:

for an informative article on fiscal policy:    and test yourself:


Also see the following piece on the taylor Rule. This you should know:

Returning to the three sets of apparatus, my own view is that none are entirely satisfactory. The 45 degree line illustrates the multiplier at work. ISLM curves emphasise the interaction between the real and the monetary side of the economy, but suffers from several disadvantages, including its assumption that prices are fixed, whilst AD-AS curves have several questionable assumptions (e.g. that relating to exports, imports and the actual importance of the Pigou effect). I tend to prefer ISLM, but it feels slightly dated. In truth none are satisfactory. The economist works by simplifying a complex world into a model which he/she can use to analyse that world. But restricting complex modern economies to just two dimensions seems to me a simplification too far. Their role is at best a teaching one, but one needs to be careful that in simplifying for teaching purposes we do not mislead.





Exchange Rates

The exchange rate is the rate at which one currency is exchanged for another, for example at the time of writing one can exchange £1 for about US$1.69. This is just about one of the hardest of economic variables to model amd to forecast. Most economists would, reluctantly subscribe to the purchasing power parity theory of exchange rates (PPP). Reluctantly because there is considerable doubt as to how well it works. But without too much exaggeration it ‘is almost the only game in tow’. Exchange rates are a crucial factor in impacting on imports, exports and the balance of trade. It is therefore essential that the student should know the PPP theory and also what the real interest rate is. However, this will not be taught in the lectures. The lectures are a guide to the course. They are not the course itself. This also includes the reading the student is expected to do. To emphasise this point I do not lecture on it. You should look up exchange rates, real exchange rates in the appendix in Lipsey and Chrystal and read and make your own notes. However this is not enough. You should then go to and read Taylor and Taylor in the Journal of Economic Perspectives. Fall 2004. Make notes on it, in two pages you should have a succinct summary which serve the place of lecture notes. Also:







Inflation is the percentage change in prices. It is often misunderstood. It is not high prices, it is not a high cost of living, it is the percentage change in prices. Now we tend to measure prices by c consumer price index, in the UK called the retail price index (rpi). This is an average of the price of a representative basket of goods which consumers buy. It is not simply a raw average, but the price of petrol, for example which typical accounts for a considerable proportion of the average person’s budget will receive a greater weight than the price of shoes. Now if we have an inflation rate of 3%, this does not mean that every price has increased by 3%, it is an average and hence some prices will have increased more than 3%, some less and some may even have fallen. For a long time inflation has been one of the key ‘targets’ of government policy. In recent years however, it has been much less of a problem and rumours abound as to the ‘death of inflation’. Such rumours may be premature.

Over the years there have been two theories of inflation which have dominated the literature. First there is the quantity theory of money. This is based on the following IDENTITY (not an equation but true by definition)

MVº PQ                                                                                                                                                                (1)

M=money supply (intuitively the number of pound coins in the economy)

V=velocity of money (intuitively the number of times an average pound gets spent)

MV= total amount spent in a given time period

P= average price of goods in transactions

T= the number of transaction, i.e. the number of things bought and sold

PT= total amount spent in a given time period

Hence (1) is true by definition. Let us rearrange

P º MV/Q                                                                                                                                              (2)

Still an identity. But let us suppose T and V are constant such that

k=V/Q                                                                                                                                                    (3)


P=kM                                                                                                                                                     (4)

Now we have a theory, (3) is an assumption not necessarily true. (4) tells us that if M increases by 10% then P also increases by 10%. Hence the way to control inflation is to control the money supply. The crucial issues are (i) are V and T really constant? and (ii) can the Government, or the Bank of England, control the money supply. With respect to (1) it does not matter too much if V and T do vary, provided (I) they vary in a predictable fashion and (2) they do not vary in such a way that P is insulated from an increased in M. For example, if an increase in M of 10% simple reduced V by 10% then nothing would happen to prices. How might this translate into an equation for a macoeconomic model? Something like:

D Pt = b 1 + b 2D Mt + b 3D Pt-1                                                                                                                                        (5)

where D Pt-1 is as always included to represent lags in economic behaviour. (Note D Pt is inflation in period t. D M is the percentage change in the money supply. This is NON STANDARD notation, generally D means the change in, not the percentage change.

The quantity theory of money is both an older theory (Irving Fisher, Chicago, 1920s and others) and a newer theory (to a considerable extent revived by Milton Friedman, Chicago, in the 1970s) as a reaction to the ‘Keynesian’ Phillips curve. When Keynes wrote the General Theory it was argued that there was a ‘missing equation’ from his model, something to explain prices. Bill Phillips supplied this with the Philips curve which postulated an inverse relationship between inflation and unemployment. The rationale for this, which I have always favoured, is a labour market one. That when unemployment is low (and conversely vacancies are high) employers have difficulty in attracting new workers and retaining existing ones. In order to help with this they increase wages, which gets passed on to higher prices. Hence:

D Pt = f(Ut)                                                                                                                                             (6)

That is it is shaped like Figure 8:

 For Figures referred to on this page click on:

Problems emerged with the Philips curve in the 1970s when we observed high inflation and high unemployment - something which was not supposed to happen. Ed Phelps had put forward a theory in about 1970 (almost simultaneously with Friedman publishing a similar one) which explained this. Basically it was argued that if workers expect prices to increase by 10% then in order to maintain the attractiveness of the wage offer,we must add to (6) expected inflation. Hence (6) becomes:

D Pt = f(Ut) + D Pte                                                                                                                                 (7)

This was known as the expectations augmented Philips curve. This is not the first time expectations have been mentioned in this course, but in the 1960s and 1970s a lot of work was done surrounding how people form their expectations. There are two main types of theories. Firstly, that people form there expectations of what is happening in the future by what has happened in the past (often termed a backward looking theory), "prices rose by 20% last year, 15% the year above, they look like they are on a downward trend I think they will rise by 12% this year). That is we extrapolate from the past into the future. The most widely used form of extrapolative expectations is adaptive expectations:

D Pet = a D Pet-1 + (1-a )D Pt                                                                                                                 (8)

That is current expectations of inflation are a weighted average of expectations in the previous period and what actually happened this period. Another way of writing (8) is that we adjust expectations according to the previous error in expectations, hence it is sometimes caused an error learning mechanism. In the mid late 60s early 70s Bob Lucas revived an idea in a paper by John Muth that firms form their expectations according to the relevant economic theory and applied it to expectations of inflation. Quite literally the rational expectations theory implies that if the relevant economic is the quantity theory of money, then workers, firms, housewives, everyone will base their expectations of inflation according as to what is happening to the money supply. This is often termed a forward looking theory.


Log on to Bank of England web site for video clip click on ‘what if’, choose windows media player broad band and you will get about a 20 minute video of Mervyn King, Governor of the bank, explaining monetary policy and indeed other things.

Also:     and test yourself:

Unemployment and the NAIRU see:

for a TV recording of this lecture which will not be given ‘live’. As with all lectures it is examinable.

Many economic models have as a starting point for unemployment that in order to produce Y(=C+I+G+X-M) you will need so many workers (LD)


subtract this number of workers from the Labour force (N) and we have the amount of unemployment


Thus one reason for unemployment is that there may not be enough demand for workers. This is derived from output and both may be expected to vary over the cycle which is why this form of unemployment is called cyclical unemployment. Policy Cure? Keynesian demand management using expansionary fiscal or monetary policy? This is problematical, and currently out of favour in many countries, partly because of the difficulties in such policy which we have already analysed. But partly because of the monetarist view of the world. ‘Monetarists’ is a relatively loose term to describe a fairly wide range of views. Once more Milton Friedman is a key player (Over the course of the twentieth century many of the leading monetarists have come from the University of Chicago including Lucas and Friedman). Briefly, in a view which has also been termed ‘the new classical approach’, they believe in the efficiency of markets including the labour market. In particular they believe that basically it will clear, i.e. the demand for labour equals the supply, in Figure 9 at a wage rate W1 and a level of labour L1. Now what would happen if the demand for labour were to fall from D1-D1 to D2-D2, would not this lead to unemployment? No the neocalssicals answer, because the wage rate will fall. Yes employment will fall as well but this is because fewer people want to work at the new lower equilibrium wage rate.

OK, but if demand equals supply surely there should be no unemployment and yet we no that in a modern economy there is never any unemployment so how do the new classical school explain that one? In several ways. Firstly, they would argue that some people will present themselves as being unemployed for the purpose of collecting unemployment benefit. But in reality all of these are voluntarily unemployed. Secondly there will always be some unemployment through people leaving one job to go to another which suits them better, or leaving firms in declining industries to move to jobs in expanding industries. The time in between jobs is called ‘frictional unemployment’ of which more later. However, what if there are no jobs for the people in declining industries to go to? This leads us to a concept known as structural unemployment:

structural unemployment. There are job vacancies and unemployed workers, but the vacancies are for computer software engineers and the unemployed workers are ex-shipbuilders. This is a skill mismatch. It may well be related to structural change in the economy which sees some industries expand and others contract. In recent years a separate term has been called technological unemployment, but in reality this is no more than structural unemployment due to skill mismatches. Another example would be where there are vacancies for office workers in London and unemployed office workers in another part of the country. This is a geographical mismatch. Again structural changes in the economy may well be to blame for this and in the long-term with the economy in full equilibrium, there would be no structural unemployment. In the last two years or say the Warwick economist Andrew Oswald has found a positive association between home ownership and unemployment. The argument is that home ownership makes people less willing to move to another part of the country for jobs. Policy cure: increase geographical mobility, i.e. take workers to jobs or attempt to take jobs to workers by e.g. limiting new office development in London, transport policies aimed at improving transport access to the regions, regional development advantages. Retraining, encourage the growth of new firms in regions faced with high structural unemployment.

frictional unemployment As we have seen even with no cyclical nor structural employment, there would still be some unemployment as workers switch jobs and also workers enter and leave the labour force. It takes time to obtain new workers. Exactly how much time depends upon informational aspects of the job market and also how keen workers are to accept unemployment. This in turn is related to the ‘replacement ratio’ (RR, the ratio of benefits to pay when in work). An increase in the replacement ratio will probably reduce the incentive for workers to accept any job offer and to continue searching for a better job. It will therefore increase unemployment.

Is this all there is to the new classical story? Not exactly, even after allowing for people who are voluntarily unemployment, for structural and frictional unemployment there still often appears to be some unemployment which we cannot explain. This may be because wages are ‘sticky’, e.g. in Figure 9 slow to move from W1 to W2 thus creating equilibrium in the labour market. What can cause wages to be sticky in this manner? There are a variety of possibilities: (i) overpowerfull trade unions who prevent wages from falling for the benefit of their members in work (even though it means that there are other workers who suffer from being without a job because of this), (ii) implicit contract theory, briefly workers dislike whilst firms are less risk averse. A very simple example: the risk averse worker is willing to say to the firm, I know that in good times I could get £300 a week, and in bad times only £250. I know too that on average there are as many good times as bad times. Because I am risk averse I am willing to be paid £270 in good times and bad. The firm bears the risk, but on average should save on its wage bill. There is an ‘implicit’ contract between firm and worker which prevents wages falling in a recession and clearing the market. (In L+C this is dealt with on page 536 under the heading ‘long-term relationships’). (iii) thirdly we look at the efficiency wage.and menu costs. Both of these are dealt with in L+C (pp.536/7).


NAIRU - the Non Accelerating Inflation Rate of Unemployment (a concept associated with the name of Steve Nickell. the Oxford University economist, but is very similar to a much earlier concept known as the natural rate of unemployment attributed to Friedman and Phelps). We made the point earlier that according to the Philips curve inflation will depend upon the level of unemployment. Let us go back to Figure 8 [the second of the two figures on the right hand side] in the inflation lecture notes. We start with a situation where people have zero expectations of inflation. A level of unemployment of U1 will then lead to a rate of inflation of 2%. Regardless of the theory of expectation formation we have if this level of unemployment is sustained people will come to expect 2% inflation. In this case the level of inflation associated with U1 will now become 4% (2% because of the basic Philips curve + 2% inflationary expectations). let is suppose unemployment continues to remain at U1, people will then come to expect inflation to equal 4% and once they do inflation will increase to 6%. When will this stop? When will inflation stop increasing? As long as unemployment remains at U1 inflation will increase without limit. The reverse argument holds for U2, i.e. we will get steadily falling prices, deflation or negative inflation. Only at U* will inflation be stable, neither increasing or decreasing. This is the NAIRU.

The Costs of Unemployment and Inflation

The costs of unemployment are the costs to the economy in foregone output, the personal costs (for example there is some evidence that the health of the long-term unemployed worker and their family suffer, as well as the impact on their income) and the impact on government financing (generally overlooked, but it will push government finances into deficit). The costs of inflation are more nebulous. There are the "shoe leather" costs associated with people faced with rising prices than expected searching for lower ones, the fact that with inflation the value of pound coins will fall and people will cut back on their optimal holding of cash. There will also be some redistribution of income from lenders to borrowers and those on fixed incomes (e.g. pensions) will fall behind. But we can overcome the latter, e.g. we can ‘index link/ pensions to the retail price index (a measure of prices). More generally, however, inflation seems to create a climate of uncertainty in which people (firms and consumers) are more likely to take the wrong decisions. But before we get too carried away with this, consider this in 1996 Korea had inflation of 5% in 1997 and growth in GDP of 11% (in real terms). I suspect what many people are afraid of is hyperinflation (e.g. in Brazil where in the 1980s and early 1990s we had inflation rates of the order of 3000%). Two final thinks is inflation dead (L+C 526 - NO!) and one final definition: hysteresis. where the NAIRU will increase after a prolonged period of high unemployment as workers get out of the habit of working and their labour market skills become dated.

The following links into a video – try real player with Ed Phelps Nobel \prize winner.



For a TV recording of this lecture which will not be given ‘live’

also see;

The equations we have specified throughout these lectures form the nucleus of a macroeconomic model such as that you have been using on the IFS website. Let us specify a simple such model:

Ct = 100 + 0.6YDt + 0.3Ct-1 - 5D Pt

It = 50 + 4.0(Yt - Yt-1) - 10rt

Log(Xt) = 2.0 + 1.2log(WDt) + 0.8Log(PCt)

Log(Mt) = 2.0 + 1.1log(Yt) - 0.8Log(PCt)

Yt = Ct + It + Gt + Xt - Mt

U = Log(Yt) - TREND

D Pt = 100 - 2Ut + 1D MSt

PCt = ERt*WPt/Pt

YDt = (1-t)Y

nt = 2.5 + 2.0Yt - 1.5MSt

rt = nt - D MSt

Let us briefly summarise these equations. Consumption depends upon disposable income lagged consumption and declines with the inflation rate. Investment depends upon changes in GDP (the accelerator) but declines with the rate of interest (the opportunity cost of investment). Exports increase with world demand (WD) and also with price competitiveness, imports increase with GDP and decline with price competitiveness, We then have the national income identity. Unemployment depends upon GDP and trend productivity. Inflation is a version of the expectations augmented Phillips curve whereby expectations of inflation are equal to current growth in the money supply (a form of rational expectations). Price competitiveness is defined as equalling the exchange rate multiplied by the price of world goods (WP) divided by the UK price of goods, Disposable income is GDP multiplied by (1- the tax rate). The nominal interest rate (nt) depends upon the depend for money (as proxied by Y, representing transactions demand) and the supply of money. The real rate of interest equals the nominal interest rate minus expected inflation (again equal to the current growth in the money supply).

You will see we have 11 equations and identities. The variables on the left hand side of these equations and identities are endogenous to the model, they are explained by the model. The remaining variables are exogenous. The model does not explain these. There are two types of exogenous variables. WD, WP and TREND are variables the government has no control over. However, G, MS, ER and t are exogenous variables under the policy makers control. We will call these the instruments of government policy. We will return to this distinction later. For the moment we shall note that the first stage of using a macroeconomic model is to specify the equations which enter the model and the variables which enter those equations. These equations will be based on economic theory, although clearly monetarists would come up with a different model to Keynesians. This also involves deciding what to include within the model (i.e. what is endogenous) and what to leave as exogenous.

The second stage is to estimate the model. This will be done using econometric techniques and need not detain us here. Just understand that we have ways of estimating the above coefficients (numbers in the equations) based on, e.g., the way the consumption function has behaved in the past. Having estimated a model it is then subjected to rigorous testing, this is done on an equation by equation basis and again involves some reasonably sophisticated econometrics, but it is also done on a complete model basis. For example, if we estimate the model based on the period 1995 to 1994 and

Historical Simulation Ex post forecast Ex ante forecast


1955 94 99 2004

use the model to simulate Y, C, I, U, etc over this same period we are conducting a historical simulation. If the model fails to simulate well over this period, then it is unlikely to forecast well and hence would not be a good model. We can also evaluate how well the model forecasts 1995-99, when the outcomes are of course well known. This is a much more difficult test than historical simulation and if it does well on this criterion we may well have confidence in its ability to forecast the future. However, it is often the case that although on strict statistical criteria each equation is excellent, when combined together into a model they do not perform well.

Having constructed a model we might use it for a number of purposes. Firstly, to forecast the future, i.e. engage in ex-ante forecasting. However, before we can forecast 2000-2004, we will need values for the exogenous variables. This means we will have to make some assumptions about world demand, world prices and the trend level of output. We also need to make assumptions about the values for the Government’s policy instruments, i.e. values for G, t, MS and ER. Of course if it is the Government or the Bank of England making the forecast these assumptions should be pretty accurate, but even we can make pretty good guesses on the basis of the Government’s stated intentions. Is this ‘all’ there is to forecasts? Not quite, when you look at the forecast value for GDP or inflation you may well feel they are not quite right. You may have a hunch as to what will happen, you may be aware that other factors are saying different things, or the Chancellor of the Exchequer may simply tell you that you forecast for GDP is too low and inflation too high. What can you do about it? You can engage in ‘con adjustment’. For example, if you change the constant term in the consumption function from 100 to 105 this will not only increase C, but feed through into Y, I, U, etc. Similarly you can reduce the constant in the inflation equation from 100 to 98 and inflation will fall. The name ‘con adjustment’ is unfortunate in its connotations, but it stems from the fact that typically we would adjust the constant terms in these equations. You then take the new forecasts back to the Chancellor who will be very pleased with you. Every single forecast you every see from a sophisticated macro model has been con adjusted. Every one, we all do it. The defence is that by and large the process does improve model forecasts. But does not invalidate the whole process of macro-modelling? Perhaps, my own view is that the model provides information about what is likely to happen which may well be at variance with your expectations as a results you forecast somewhere in between. If this proves better than your original expectations, the model has done its job. Remember too the Treasury model may have some 600 odd equations, but these have to model the complex interactions of 55 million people plus thousands of firms.

But models can also be used in policy analysis. You for example have experimented with changing some of the ‘instruments of government policy’ with a view to examining their impact on some of the ‘targets’ (growth, unemployment, inflation, balance of trade). The Treasury do this also with their budget and expenditure plans. The Bank of England too have a model of the economy, they will be putting the budget changes through this model with a view to what will be its effect on inflation. If it raises it above their 2.5% target then the Monetary Policy Committee will raise interest rates accordingly. The techniques also exist for models to give answers to the question what should interest rates, taxation and G be to maximise welfare. You will have to provide information in the form of what, for example, you wish unemployment and inflation to be. One can also use models to forecast for example the impact of us joining the Euro, or alternatively of us leaving the EU. But remember the more unusual the question you ask of a model, the more removed from past experience, the more uncertain will be the answers the model gives. It is best used for looking at the impact of small changes in policy instruments over the medium term (say five years). Note too that the techniques we have illustrated here could be easily transferred to building a model to forecast sales of a particular product for a firm, or the impact of a price change or an advertising campaign on profitability.



You will note that the model we specified is Keynesian in the sense that it is centred around the GDP identity. GDP equals the sum of Consumers expenditure, investment expenditure and so on. This then gives us total output, this determines unemployment which feeds through into inflation and so on. Most models are of this type. Monetarist models tend to differ from Keynesian ones not in the structure of the model, but in its properties. For example, in A Keynesian model the multiplier will be much greater than the monetarist model where its long-run value may well be zero. We do not have to model things this way. We could take the alternative approach - which is probably the way people used to think of things prior to Keynes - of what is the economy capable of producing? This then is divided up between consumption, investment etc. A few models have done this, they have had some impact on our theoretical understanding of the economy but little real impact on macroeconomic modelling. There has been even less research done on what we might call disequilibrium models. Let me illustrate this. The national income identity now determined the total level of demand (YD) in the economy:

YDt = Ct + It + Gt + Xt - Mt

Potential output (YSt) is given by a production function linking output to the labour force and the capital stock:

YSt = f(K,L)

Actual output is equal to the minimum of the two:

Y = min(YS, YD)

If YD < YS then we are in the Keynesian world. The possibility that YD > YS is rarely analysed. At best the statement would be that we are in the vertical section of the aggregate supply curve, with inflation and FULL EMPLOYMENT. The possibility that YD > YS with significant levels of unemployment is just not considered. But let us examine what happens in a recession. Output falls, unemployment rises, profits fall and some firms go bankrupt and other firms cut back on there operations. Either way capital is likely to be scrapped. We have seen this many times with the decline of the coal industry, the collapse of shipbuilding, the loss of the motor bike industry.

A simple model illustrates this:

YS = 10K

L = 0.5Y

YD =2000

Y = Min(YD, YS)

L = 0.5Y

With K (capital stock) = 200; YD =2000, the economy is in equilibrium with aggregate supply equal to aggregate demand and L (the number of workers in employment = 1000. In this particular economy that is all the workers there are. Now let us suppose a ‘shock’ hits the system and reduces aggregate demand to 1800. If wages are fixed (i.e. ‘sticky’ to use the prevailing jargon) then L will fall to 900 and 100 workers will be unemployed. The Keynesian remedy is to increase Government spending or cut taxes in a bid to boost YD back up to full employment level at 2000. (The monetarist remedy is to try and change the labour market so as to make wages less ‘sticky’). But there is a potential problem with the Keynesian solution what if the recession reduced profits and this led to an increase in bankruptcies and the loss of capital stock? Let us suppose this results in capital stock falling from 200 to 190. YS now equals 1900. Keynesian policies will work as long as they seek to boost output between the range 1800 to 1900, beyond this range, they will be pretty ineffective. Within this range YD > YS, several things are likely to happen (i) inflation will rise as the demand is greater than what the economy can produce, (ii) the balance of trade will worsen as unsatisfied demand for domestic goods is made good by imports and (iii) profits will increase and there will be a boost to investment (both by existing firms and new company starts). Over time this increased investment will boost YS back up to 2000 where full employment will be restored, but in the meantime we will have inflation and a balance of payments deficit. This perhaps is the story of Keynesian policy and the economy in Europe in recent decades. We have seen high unemployment, and in historical terms even in the UK it is still quite high, in the UK and Europe throughout much of the last 20 years. There has been much analysis done on this, particularly in comparison with the US economy which has since the early 1980s been much more prosperous with much lower levels of unemployment. Perhaps the consensus amongst many economists is that this is down to the increased flexibility of the US economy, particularly the labour market, with greater willingness of workers to move, with it easier to dismiss workers, with wages more flexible. Doubtless these factors play a factor, but I still think my bankruptcy story has a role to play. But you must be aware that this is not a common view, indeed if you look up ‘bankruptcy’ in L+C you will not find it.

But how can it explain why the US has not suffered the same problems as Europe? Surely bankruptcies have the same effect in the two. Well in fact they do not. The UK (and European) and the US systems are to an extent at opposite ends of the spectrum in terms of their emphasis, although perhaps not in the way that might be expected. The UK system has as its emphasis the recovery of creditors money as efficiently as possible. Although in this to a considerable extent it fails due to the emphasis, in common with most other countries, it places on the secured creditor (typically banks and financial institutions). Frequently we have a situation whereby in the advent of corporate failure the secured creditor loses very little and the unsecured creditor almost everything. The relevant legislation is Chapter 11 of the USA Bankruptcy Code introduced in 1979 by which troubled firms can seek the protection of the Court against creditors, even secured creditors, seeking to close them down and recover their assets. The firm has to come up with a ‘survival plan’ and the Court can FORCE creditors to accept this. The legislation is controversial. But it may well have had the effective of preserving supply side capacity within a recession. Hence when there economy emerged from a recession in the early 1980s it did so with aggregate supply intact.

But the legislation is controversial. Bankruptcies perform several conflicting roles within the economic system. Firstly, they are the engine of Schumpeter’s process of creative destruction by which the old (and inefficient?) give way to the new (and efficient?), thus paving the way for economic process. Resources are redistributed within the economy within an optimal manner towards industries where there marginal productivity will be greater. In this way we make progress. Bankruptcy procedures also perform the role of allowing the failing firm’s creditors to recover their money. This is an essential part of the incentive structure in a capitalist system, firms and individuals are encouraged to ‘lend’ money (often implicitly by, e.g. paying for goods in advance of their delivery or alternatively supplying products in advance of payment) in the knowledge that if things go wrong there is a process open to then to retrieve their money. An ‘optimal ‘ bankruptcy system must seek to balance these differing perspectives. It must provide for the efficient ‘disposal’ of firms in declining industries or the simply inefficient entrepreneur, whilst simultaneously minimising the loss of potentially viable firms. In addition it must provide for the retrieval of as much of creditors money as quickly as possible. Clearly many of these are conflicting objectives and the optimal bankruptcy system must seek a compromise between these different objectives.

One final point to note. The term ‘supply side economics’ is a term associated with right wing economists - frequently monetarists, who argue that low taxes are distortionary and, e.g. a cut in income tax would stimulate labour supply and effort - in effect shifting the aggregate supply curve to the right. The same is true of, e.g. reducing taxes on firms, which would stimulate investment, increase capital stock and again shift the aggregate supply curve to the right. The term is also associated with those who would, for example, cut unemployment benefits in an effort to increase the incentive to work and increase the flexibility of the labour market. Clearly, even ignoring the arguments I have put above this is a relatively limited view of what impacts on the supply side of the economy. For example, education which increases labour productivity will also shift the aggregate supply curve to the right.

See: Does Chapter 11 Reorganisation Remain a Viable Option for Distressed Businesses for the Twenty-First Century? By: Miller, Harvey R.; Waisman, Shai Y.. American Bankruptcy Law Journal, Spring2004, Vol. 78 Issue 2, p153, 48p; (AN 14743936)

Also: In The USA:


In The UK:


Also look at the following paper, the introduction, the section entitled “American Bankruptcy and Chapter 11’ and the conclusion.


Terminology is inexact. When people talk of cycles they often mean the economy booms and then the economy goes into recession rather than follows an even path across time. Thus the causes of ‘the cycle’ are the causes of the ‘boom and bust economy’ (which you will note that every Chancellor of the Exchequer since Selywn Lloyd in the early 1960s has ‘successfully’ eradicated). Strictly speaking however, a cycle is more than that. It is the regular nature of occurrence of booms and recessions that make a cycle. Thus a four or five year cycle which constitutes what is commonly thought of as the business cycle means that EVERY five years growth will peak. Now clearly this is very much more than just boom following bust in a random manner. And leads to consider issues such as what could cause such a regular occurrence. What are the possible causes.

1. Political: At the moment probably the dominant cause of the cycle is political linked to elections What determines the outcomes of elections? "the economy, stupid". With this dictum in mind Governments try and steer the economy so that at election time, as much as possible of the following is true, unemployment low and/or falling, inflation low, growth high, incomes rising, taxes falling and public services improving. The exact mixture between falling taxes and rising expenditure on public sector spending varies between left and right wing Governments. But typically about two years before an election, the economy will receive a fiscal boost from the Government in the form of increased G or falling taxes. This is frequently augmented a year later. Then once the election is safely out of the way, Governments will reverse this policy, partly out of economic necessity as the economy overheats, inflation and the balance of payments begin to worsen. In general governments do the nasty, unpopular things early in their term of office. But they will also make savings so as to create a ‘war chest’ which can be given away in time for the next election. Now being as elections are about every four years in many countries, but in particular in the US which to a large extent is the engine of the World economy, we get a four year business cycle. As a matter of interest you can log into Ray Fair's web site then click on the presidential vote equation; then click on compute your own prediction for 2012, although it’s a long way off. You can see it links the election outcome to growth and inflation and that is why Obama won last time. But election models often take into account much else, and I would expect future work to conclude that the Iraq War exerted a negative impact on the vote just as the Vietnam War did for Lyndon Johnson.

2. Economic: Systematic Shocks. All the components of GDP have a stochastic (random) component. One theory of the cycle is that a negative shock hits for example consumers expenditure, there is some sort of adjustment process which generates a cycle. For example, a negative shock in 2000 to consumers expenditure, firms will respond with a lag by reducing output and laying off workers, investment will decline which calls forth a further reduction in output. Thus even if the shock is a one off with no further impact on consumers expenditure 2001 may still see a reduction in GDP below its equilibrium level, only over time and with no further shocks will this equilibrium be restored. However in 2002 there may well be another shock which once again knocks the economy off course. There is probably something to this theory, but I remain sceptical about how RANDOM shocks can produce REGULAR movements in GDP. Sure it can explain booms and recessions but NOT regular booms and recessions every four to five years.

2. Economic: Accelerator Multiplier Interaction. There is a permanent shift in GDP say from 1000 to 1100 which means that capital stock should increase from 500 to 550. However as investment is in itself part of GDP this increases GDP too an increases exacerbated by the multiplier so that GDP rises to 1200 which calls forth another increase in investment which is also exacerbated by the multiplier so that GDP now stands at 1220 and capital stock has increased to 610. At this point output has hit a ceiling, no further output is possible. Hence investment because of the accelerator falls to zero and output falls back towards its equilibrium level of 1100. But to produce this we simple need a capital stock of 550, whereas in reality capital stock has increased to 610. Faced with excess capacity firms will cut back on replacement investment (investment which replaces worn out machines etc, but does not add to capital stock). This too is part of GDP which hence will remain below its new equilibrium level of 1100 until capital stock has once again fallen to 550. This is illustrated in Figure 27.2 of L+C but the diagram is wrongly labelled it should say equilibrium real GDP not just real GDP.

See (particularly Hicks’ trade cycle after Figure 1):

The business cycle is not the only cycle economists have studied. Early research focused on an eleven year cycle which was linked to ‘sun spots’. These are spots on the sun which coincide with extra large periods of emissions of solar flares and x and other rays. They have a regular 11 year cycle and were thought to influence agricultural conditions at a time when agriculture was much more of a driving force in the economy than it is today. We shall be concentrating on a possible 50 year cycle linked with the Russian economist ‘Kondratief’. Working in the 1920s he suggested the existence of such a cycle (or long wave) by looking at data for Britain, France and I think the USA. He was mainly concerned with trends in inflation and interest rates. The upswing of the first ‘long wave’ he detected covered the period from 1789-1814 that is the 25 years beginning with the French Revolution and ending with Waterloo. The subsequent decline lasted for 35 years ending in 1849. Thus the whole cycle lasted some 60 years. The upswing of the second cycle lasted for 24 years ending in 1873 whilst the downswing lasted until 1896, hence the cycle covered 47 years. . The third part of the cycle moves upwards until 1920, once more a period of 24 years. Kondratief thought these cycles to be an inherent part of the capitalist system but beyond this he declined to be more specific. Thus to an extent his work is little more than a set of statistics in search of a theory and because of this has frequently been ignored. But there is still interest in this partly because he predicted the depression of the 1930s AND the depression which has gripped most capitalist countries (exception of USA) at some time since 1980.

Schumpeter’s explanation of the business cycle is relatively straightforward. It centres on the concept of innovation, a change of first magnitude (electricity, the railways, the microchip). Prior to this the economy should be in a state of near-equilibrium, where the economy has seen few recent innovations and entrepreneurs are beginning to be put under pressure as the expansion of old markets has dried up. Hence they will be receptive to new ideas (note the innovation may have been invented years even decades before, but it needs entrepreneurs to take it up and this they will do when the profits are under pressure). This primary wave of innovation is succeeded by a secondary one brought about by induced purchases of inputs and consumer goods. The upswing ends as the potential for exploiting the new innovations dries up and also because many enterprises begun in the secondary wave may not be viable in the long-run. The downswing may simply take the economy back to a new equilibrium in which old patterns of production have been replaced by new ones. An inevitable part of this is the disappearance of old firms and the transfer of their resources to new ones. A process he called ‘creative destruction’ and which he thought essential to the workings of the capitalist system. He was therefore against government action to stop the contraction of old industries such as tariffs, subsidies or cheap loans, even though there is the possibility that in the downturn the economy might overshoot equilibrium and go into recession (too many unviable firms get started in the secondary wave and there demise pushes the economy into recession). Thus the first part of the cycle is a wave of entrepreneurial activity built on a cluster of new innovations. New firms being attracted by the high profits being earned by the innovators are attracted into the industry. But there is soon overproduction and capacity. Many firms will have borrowed heavily and excess capacity drives prices and profits down, they will experience difficulties, perhaps even becoming bankrupt.

Schumpeter had little to say about unemployment and wages as such. But his policy recommendations to deal with business cycles can be found in The Theory of Economic Development. The most important remedy in the long-run was the greater familiarity of businessmen with the working of the cycle. Foreseeing what is likely to happen in the future helps them to take steps to neutralise cycles. In the short-run he also favoured Keynesian-type government expenditure policies whereby new construction by government enterprises is postponed to periods of depression. (note he was writing in 1911, pre-Keynes). With respect to monetary policy he was against an indiscriminate and general increase in credit facilities which he linked with inflation, but also hindered the closure of firms in declining industries. However, he did favour a selective monetary policy aimed at differentiating between those firms made obsolete by the innovations from other firms, in trouble for a variety of temporary reasons, but not fundamentally unviable.




Macroeconomics is not just about one country at one point in time. If it is valid, its is applicable to all countries. We now look at developing countries.


Aid in its modern form has been with us since 1950. Its purpose has been to lift countries out of poverty and propel them on the path to a stage when they do not need aid. That is they are n a path of self-sustaining growth and out of poverty. South Korea is a success story. But there have not been many and if it is too much to say aid has ‘failed’, then it has certainly not been as successful as we would have hoped. In this lecture we look at the reasons why.

For video on aid See:

 also see:,,pagePK:50004410~piPK:36602~theSitePK:29708,00.html

and look on ‘the world bank video clip and also the Africa slide show (towards the bottom of the page).

Reference: Symposium on Aid in June 2004 edition of the Economic Journal.

MHV - Mosley Hudson and Verschoor paper; CD - Collier Dollar paper and DHT Dalgaard, Hansen and Tarp

How does aid work?

Take the production function: Y =f(K,L)

Theoretically perhaps the main impact of aid, at least in the early years, is to increase capital stock K and from this output increases and hence so do living standards. Aid could also impact on the quality of L (the labour force) via funding education. But aid is intended to be more effective than this. When a country is very poor – with large numbers of people earning less than a dollar a day – the resources are not really available to finance significant amounts of investment from savings nor for governments to finance public goods and infrastructure from taxation. By providing aid, increasing K and GDP it is hoped that this will change that countries will be able to fund public and private investment from their own savings and taxation.- self sustaining growth in the words of Rostow back in the 1950s.

The Impact of aid on Growth

Food aid, health aid, emergency aid


Impacts on price mechanism





Empirical work

The debate on the impact of aid on the economies of developing countries is a rapidly evolving one. Early studies by, e.g., Papanek (1973) reported a positive impact of aid on growth within a multiple regression context. This conclusion allowed policy makers to entertain the possibility that poverty across the world could be largely eradicated. Unfortunately after some forty years the poor are still with us, poverty shows relatively little signs of disappearing and until recently enthusiasm for aid amongst donors had declined.

A number of economic studies help explain and clarify this apparent failure. Mosley, Hudson and Horrell (1987) found it impossible to establish any significant relationship between aid and the growth rate of developing countries. They suggested that this might be because of the possibility of leakages into non-productive expenditure in the public sector and the transmission of negative price effects to the private sector. The former is the problem of fungibility. Aid intended for some capital infrastructure project gets spent on the military, or cars for government ministers or even tax cuts. Perhaps even more worrying is high level corruption. To put it at its simplest aid goes into the pockets of the ruling elite. More on this is given later

The price effects? A very simple example. A large construction project funded by aid pays workers high salaries. Farmers leave their farms attracted by the high wages. The project lasts four years. Four years of good wages, but at the end of this the farm has deteriorated and is difficult to grow crops on. Another example, if aid is used to subsidise bread and other food products, this keeps their price ‘low’ and reduces the incentives for home producers.

More recently, however, work by Burnside and Dollar (2000) (who were then at the World Bank) was to put forward a more optimistic view of aid effectiveness. They concluded that aid had a positive impact on growth for those developing countries with good fiscal, monetary and trade policies in place, but had little impact for those countries who were following poor policies. This therefore, partially at least, provided an explanation of why aid had been found to have little positive impact on growth in previous empirical work. It also provided specific criteria for targeting aid. This was then built upon by Collier and Dollar (2001 and 2002) (Paul Collier was then at the Bank, and later moved to Oxford) who calculated a ‘poverty efficient allocation of aid’ which focused on those countries with a combination of the most poverty and best policies. They suggested that targeting of aid in this manner would almost double its effectiveness in reducing poverty.

This work has had an extraordinary impact upon policy and Easterly (2003) as well as Dalgaard, Hansen and Tarp document how it has influenced both individual governments and international organisations – including the American government. Once more the eradication of poverty is a goal to which donors can and do enthusiastically commit and for this reason alone their work is of great significance.

However, it has not been without its critics. For example, Hansen and Harp (2001), have argued that the inclusion of an aid squared term, implying diminishing returns to aid, neutralises the significance of the aid-policy interaction term (i.e. aid does work and it works whether or not combination with good policy, but its effect is nonlinear). Dalgaard and Hansen (2001) also conclude aid’s positive impact on growth is characterised by diminishing returns (i.e. nonlinear again, a moderate amount of aid goes a long way, double it and its not so effective). Similarly Easterly argues that the Burnside-Dollar conclusions are not robust with respect to alternative, "equally plausible" definitions of aid, policies and growth. This is important as if the criticisms are valid, aid allocation rules based on the importance of good policies will unfairly penalise some countries.

As an aside this characterises applied economics. We have limited amounts of data to work with and are trying to explain a complex world with just a few variables. Slightly change an equations specification and results can change.

Good policies

The first issue to consider in this context is what constitutes good policies. Burnside and Dollar began with a vector of variables, inflation, unemployment and trade openness which are basically macro focussed and probably endogenous with respect to growth at the very least. CD partially recognising the limitations of restricting good policies so narrowly make use of the CPIA, as in their earlier papers (Collier and Dollar, 2001 and 2002). This is a World Bank measure which assesses a country’s policy and institutional framework in twenty dimensions, including e.g. economic management and policies for social inclusion. Hence compared to the original Burnside Dollar this is wide ranging indeed and undoubtedly a significant step forward.

A key element of the debate is whether either conditionality or selectivity is the appropriate form of linkage of aid to policy. Conditionality is the giving of aid to developing countries on the basis of promises to follow good policies in the future. CD argue that such promises are seldom kept and that, e.g. work by Alesina and Dollar (2000) finds no relationship between official finance and policy reform. They argue that aid donors should base their allocations upon good policies being in place now, rather than promises that they will be in the future.

I have always believed – unlike others in the debate - that the differences between selectivity and conditionality are superficial. The one says you get aid if you promise to be a good boy or girl in the future pursuing proper policies. The other says you get aid if you have pursued good policies in the past. But both are supposed to reward governments who follow good policies and thus provide an incentive for them to do so. Conditionality offers the advantage that it can by negotiation tailor appropriate policies to a countries needs. But it needs to be properly policed with punishment for countries who renege on promises. Selectivity is strong on enforcement – you only get aid if you already have good policies in place, but is a little less flexible in terms of tailoring policies to meet specific country needs. In addition it ignores the possibility that good policies may be facilitated by aid, i.e. aid may be a precondition for the implementation of good policies.

The debate has not been without a certain amount of heat and passion – rightly as this is a critically important issue. That should not, however, disguise the considerable amount of consensus which now exists on the central question of whether aid impacts positively in reducing poverty. The answer is in some circumstances, YES. Different economists simply disagree on the circumstances.

The Economist’s Dilemma

Aid comes in many forms including orientated towards health, food and emergency aid (e.g. Tsunami). Not all of these will impact upon GDP and poverty as indicated above. They are not meant too. But paradoxically there may be adverse affects. Take expenditure on health which reduces infant mortality. More children live to adulthood, but without a reduction in the number of children per family one is simply expanding the population beyond what the economy can support and quite possibly condemning the country to permanent poverty. Economics is a hard science. The figures below illustrates this.

Figure 6 shows that in low income countries as a whole the age dependency ratio [the ratio of those not of working age to those who are] rose in the period 1960-1971 although it has since fallen back to below the level in1960. But for (sub-Saharan Africa) SSA the peak was only reached in 1987 and by 2005 was still above the level in 1961. This average hides a range of trends and in some African countries such as Uganda it remains on an upward trend. An increasing age dependency ratio. reducing the ratio of working to total population will act as a drag on the growth of income per capita. If part of the cause of this increase in the age dependency ratio is reduced infant mortality brought about by aid without simultaneously reducing the birth rate, which is what we have seen in much of SSA, then the impact of this aid will not only fail to stimulate growth it will, in the short term, have negative impacts on growth. We emphasize the short term as when the children reach adulthood there should be a decline in the age dependency ratio and the labour force should increase, giving a delayed boost to growth. This is now what we are seeing in many developing countries and hence in this respect the climate for aid having a positive impact on growth is more propitious than in the past.


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A More in Depth Analysis of Why Aid Does not Work as well as it should.


Fungibility is the switching of aid money into non-productive uses, typically the provision of rents to politically powerful people (Feyzioglu et al. 1995). The good effect of aid-financed projects (the main micro result) was counterbalanced, in a number of ‘less open’ economies, by switching of aid into wasteful consumption expenditures to gratify the preferences of rent-holders.


Fiscal and other management

There is a risk that aid may erode the tax base, It is a form of revenue, hence why try to raise money from other sources? indeed Moore (1998) and Brautigam (2002) demonstrate a negative correlation between aid inflows into a country and the size of its tax base. Of course, the pattern of causation cannot be inferred from a mere correlation, and it is clear that there are some African countries which have escape from the vicious circle, notably Ghana (where tax revenues have increased from 12% to 23% of GNP between the mid-1980s and 2005), Uganda and Tanzania.


Corruption, governance and state fragility

During the 1990s, it became clear that the failure of poor, ‘non-convergent’ developing countries to grow or reduce poverty was often associated with the failure of governments and associated institutions to function in a just and transparent way. The role of aid broadened from simply the improvement of efficiency and equity to the improvement of governance, and aid effectiveness must now be judged not only in terms of its ability, in the short term, to improve growth performance and reduce poverty, but also in terms of its ability to improve the performance of governmental and non-governmental institutions over the long term. Once more this is linked to the concept of conditionality and opens up the way for not only aid effectiveness to be improved as it is used in the way donors intend, but from a further knock-on effects from the improvement in governance. 


In an important paper focused on Africa Brautigam and Knack (2004) find that in high aid-dependent countries aid provides more opportunities for, and thereby increases the level of, [the Transparency International index of] corruption and also reduces tax effort. It thus has a long-term depressive effect on institutional quality. If these findings are correct, they imply that what appears now to be a positive short-term effect of aid on growth and even on poverty is being undermined by long-term forces of institutional erosion which could cause the short-term effect to be unsustainable and once more brings into question the whole rationale for aid.


Absorptive Capacity Problems

Absorptive capacity potentially affects all developing countries. De Renzio classifies the constraints under several headings: (i) Macroeconomic Constraints. Sudden positive increases in aid inflows can cause an appreciation of the currency, damaging exports, i.e. Dutch disease, (ii) Institutional and Policy constraints. Aid requires expertise and organisational infrastructure on the part of the recipient to be able to administer it effectively. These are often in short supply in many recipient countries and a sudden increase in aid can stretch them beyond the limit and (iii)Technical and managerial Constraints. Other forms of human capital are also frequently in short supply. This is evident in for example, the number of doctors, teachers, nurses, administrators and managers.


Donor Coordination

Roodman (2006b) focuses on problems arising from the recipient’s administrative burden. He concludes that when projects proliferate beyond a certain point, the effective marginal utility of aid declines sharply, and can even become negative. There are also the simple transaction costs of dealing with a large number of donors. In 2002 there were 25 official bilateral donors, 19 official multilateral donors and about 350 international NGOs operating in Vietnam accounting for over 8,000 development projects. (Acahrya et al, 2003, also Knack and Rahman, 2004). 


Donor Consistency

It is fairly clear from the micro-literature that, other things being equal, instability in aid flows tends to depreciate its quality. This confronts aid donors with a fundamental dilemma, since the ‘reactive’ forms of aid have been introduced, precisely in order to improve the quality of aid by making it more performance – and need-responsive. In other words there is a trade-off: if the donor seeks to improve aid quality by reducing volatility, most ways of doing this – e.g. reducing the penalty for poor performance on budget support aid – will reduce the donor’s flexibility. An attempt has been made to finesse this dilemma by Gelb and Eifert (2006), who propose that, in the event of a negative shock to aid disbursements caused for example by a fall in the recipient’s CPIA rating, this should be automatically counteracted by drawings on a buffer fund, which would stabilise aid disbursements.

Aid Volatility

There has been some recent work looking at aid volatility and its potential impact on aid effectiveness. The idea is that a steady stream of aid of, e.g. 2007: 5%; 2008: 5%; 2009:5% is more effective than more volatile aid flows: e.g. 2%; 12%; 3%. In the following paper we establish that this is indeed the case and in addition downside (negative) volatile (aid shortfalls from the average) are more destructive than upside (positive) volatility. The former can cause the cancellation of projects. The latter can cause absorption problems, i.e. they have difficulty in using the aid in a constructive manner. There are also problems for aid recipient countries in the number of donors it may have to deal with in a country, aid donors such as DFID (UK) and also the World Bank, but also NGOs. This takes time and effort and uses up scarce bureaucratic resources.

The following regression table illustrates this (taken from the paper referenced at the end of this section.

Table 7: Regressions of Residuals on Growth

Dependent Variable: Annual Growth of GDP

(Figure 3, equation 1)

Estimation method


Random Effects

Fixed Effects

Random Effects AR1

Fixed Effects AR1

RandomEffects IV

Fixed Effects IV










38.63 **




































Aid GDP ratio













































Positive Volatility t-1















Negative Volatility t-1















World Growth
















Sub Saharan Africa












S. America























































**/* denotes significance at the 1% and 5% levels. Wald statistic denoted by W. The figures in parentheses are t statistics. ROUGHLY a value greater than 1.96 indicates that the variable is significant at the 5% level and greater than 2.57 at the 1% level.  If the coefficient is positive it indicates that that variable increases growth. If it is negative (like disasters) then an increase in the variable reduces growth. NOTE this is more than correlation we are analysing the causal impact of aid on growth GIVEN what is happening to all the other variables.


Table 7 presents regression results of the determinants of growth In the first column Aid is significantly positive at the 5% level. However, this is somewhat neutralized by the impact of aid volatility. The results suggest that both positive and negative volatility reduce growth, and in the results we have for the most part combined the two together. However, this does not mean that the two are symmetric in their impact. When we look at lagged volatility there is a substantial difference in their impact. Negative volatility is insignificant, whilst positive volatility is significant and reduces some of the previous harmful impact on aid. If the problems raised by positive volatility are linked with absorptive capacity as is suggested in the literature, these results suggest that these are to an extent short term only and are reversed in subsequent periods. But with negative or downside volatility there is no such reprieve. The disaster variable is also significant in reducing growth. Of the other variables, growth in the OECD countries is transmitted to the developing countries in the current period. There is also a catch-up effect by which growth in developing countries tends to be greater in the poorest countries and the regional dummy variables are also of varying significance. Finally lagged inflation, representing a good policy environment as in the original Burnside and Dollar (2000) paper, is significant with the anticipated negative sign. In the remaining columns we used standard fixed and random effects and then correcting for autocorrelation.

Authors: Hudson, J.; Mosley, P.
Journal: World Development Year: 2008 Volume: 36 Issue: 10 Pages: 2082-2102 Provider: Elsevier



Post Script I

For many years Sub Saharan Africa has been the region which has posed most problems, stubbornly stuck in poverty, blessed with huge riches, cursed with corruption, bad governance and war. Part of the problem is that mineral wealth brings with it corruption (The Resource Curse). Also these countries are artificial, created as a result of colonialism. Look at a map of Africa, borders are straight lines. Look at Europe and Asia, few straight line borders. Hence people do not identify with the country s much as with the tribe. But there is beginning to be hope. Take a look at this:Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: growth


Post Script II A Slight problem

Climate change is a real problem. It has many aspects. Most, but not all countries, will lose. Coastal areas will disappear. Many major cities are on coastal areas and are at risk. Below is one aspect of this taken from the World Development Report 2010 “Development and Climate Change”.

Post Script III

CD also look at the use of aid not simply to reduce poverty per se but to promote security which is a fundamental goal in its own right. Although the distinction is not absolute and most low income countries have recent experience of civil conflict. CD report work which shows that the risk of conflict is linked to economic growth, income per capita and dependence upon primary commodity exports. Both aid and policy impact upon these characteristics and hence can be used to reduce the risk of conflict. They report results that (P253) show the effect of a $1 per capita per year additional aid program maintained for 5 years and a one point improvement in good policies also sustained over five years. For the average aid recipient country the conflict risk in a five year period is 11.3%, a one in nine chance that a major civil conflict will be initiated. The aid policy improvement package reduces this risk to 7.9%.and policy reform alone reduces it to 8.6%.

All of this is to illustrate something fundamental. Seldom is there a last word in economics. Seldom is a theory proved entirely correct and that is the end of the matter. The world changes, our resources change, more sophisticated econometric techniques, greater availability of data. An economist writes a paper and if it makes an impact – most do not – then others build upon it, accepting part, rejecting other parts. Hence the CD results on aid and conflict are suggestive and interesting, but just that, not the final word. Theory moves forward in stages, by argument by discussion in this the most challenging and important of academic disciplines.




In looking at growth in developing countries, it was emphasised that the source of growth is the firm. If an economy is to grow, if a low income country is to catch others up, then it has to increase productivity. But this is equally true for the UK, the EU and North America. The economic crisis in part has been about a shift of power to the East. If the ‘old world’ is to maintain its prosperity both in absolute and relative terms, then productivity is key. We will begin this analysis by looking at productivity in the UK. We will then extend it to analyse China and finally innovation in productivity in all countries.



The question we are looking at is why are some areas more productive than others and why are some firms more productive than others. An understanding of this is crucial to generating high GDP and reducing unemployment. The paper on which this research is based is:


Regional productivity differentials in England: Explaining the gap
Authors: Webber Don J.; Hudson John; Boddy Martin; Plumridge Anthony
Journal: Papers in Regional Science Year: 2009 Volume: 88 Issue: 3 Pages: 609-621 Provider: Blackwell


In this lecture, I will also be teaching you how an applied economics paper is written. A typical economics paper has the following components, a review of the literature, a theoretical section, which produces testable conclusions and empirical work which tests those conclusions. Finally a concluding section will partially summarise the work, but also draw further conclusions or implications. We illustrate that with respect to productivity.




“The government’s central economic objective is to achieve high and stable levels of growth and employment.  Improving the economic performance of every country and region of the UK is an essential element of that objective, firstly for reasons of equity, but also because unfulfilled economic potential in every region must be released to meet the overall challenge of increasing the UK’s long-term growth rate” (HM  Treasury, 2001, v)


Similarly, at an EU level, regional competitiveness and productivity differentials have been seen as particularly significant both in terms of closing the gap between the EU, the USA and other major competitors in a global context but also specifically in relation to objectives of social cohesion at European scale – particularly in the context of monetary union and the enlargement of the EU to include a wide range of less economically buoyant regions and nation states (Gardiner et al, 2004).


The Literature


Gardiner et al, for example distinguish between  neo-classical growth theory which emphasizes the importance of capital stock per worker and technology; 


endogenous growth theory emphasizes technology, the knowledge-base and knowledge workers;


the new economic geography emphasizes the significance of spatial agglomeration, clustering and specialization as the basis for increasing returns. Spatial agglomeration is, e.g., the economies of scale you can get in large cities viz a viz low population density rural areas.  Clustering is the close geographical proximity of firms in the same industry. For example, Silicon Valley in California. Specialisation is e.g. when a form focuses on its core activity and gets other firms to do other things (e.g. deliver the product).


For the UK, Rice and Venables  examine the determinants of spatial productivity differentials across the UK.  Drawing on recent theories from new economic geography they then relate productivity differentials to a measure of economic mass – constructed on the basis of drive-times and the size of the working-age population in relation to each region.  They find a significant effect of proximity to economic mass on productivity – greatest within 40 minutes drive time and tapering off quite steeply to zero beyond around 80 miles.  They suggest that doubling the economic mass associated with a particular region increases productivity by 3.5%. 


Other studies have shed light on the determinants of productivity by focusing at the level of the individual firm as opposed to territorial differences.  Barnes and Haskell (2000) demonstrate the wide dispersion of productivity levels with the top decile [10%] of establishments between 3.5 and 6 times as productive as the bottom decile, depending on the sector.   Criscuolo and Martin (2003) find strong evidence of a US productivity advantage which is consistently greater than other multinational enterprises (MNEs).  However, they find that MNEs per se also have a productivity advantage over other non-MNEs.




In modelling regional productivity differentials, we assume, as is common, a Cobb Douglas production function:




where K is capital stock, Y gross value added at factor cost (GVAFC) and L is labour force.  A represents efficiency factors which we model as a function of all the factors that may impact on productivity and output, such as locational variables, ownership, skill variables, etc.:


A = exp(β0 + β3X + Industry variables + Regional Variables)                            (2)


Taking logs gives us:


Ln(Y) = β0 + β1ln(K) + β2ln(L) + β3X + Industry Variables + Regional Variables       (3)


The regional variables show the extent to which output in a specific region differs from the ‘control or benchmark region’ in percentage terms (we define this as London as the region with the highest level of productivity based on aggregate ONS data) given the firm’s industrial sector and the size of firms in the region.  We are looking at total output, i.e.  GVAFC (Gross value added at Factor Cost) , but the analysis is totally consistent with focusing on labour productivity or indeed capital productivity. 


The key factor is what to include in X, i.e.  the set of independent variables other than labour, capital, industry and regional variables.  To an extent this is dictated by the literature that has been reviewed above.  We have seen that it has been suggested that multinationals are more efficient than non-multinationals and US multinationals are generally found to be more efficient than other multinational firms.  Locational variables have also been found to be significant in determining productivity.  Hence we will also include population density and distance factors, but unlike most other analyses we include travel time as well as distance in miles.  This is an important distinction.  The former can be impacted upon by economic policy whereas the latter cannot.  Skill variables are also found to be significant in many analyses.  Here we include skill levels in the local authority area in which the individual establishment is located as a measure of skill levels in the local labour market.  Again, this is a level at which policy measures might be expected to have some potential leverage on skill levels that might, in turn, impact on productivity.


All very well but we need a theory at this point (although for an economics paper it would need more maths than this), lets start with a model which says that the latest innovation and best practice techniques are introduced in a few key locations. Firstly because these are the locations where they are most likely to succeed because perhaps of a consumer population most receptive to new techniques. In the UK London is an obvious example, it has a relatively wealthy population, many with high levels of education and many indeed migrants – permanent or temporary from other countries. They should be most inductive to new ideas. Also many exhibitions, are based (today) at the Excel centre in Docklands. New, successful innovations then spread out to the rest of the country at a speed inversely proportional to distance from London. This is why you can get internet connections at hotels in London more frequently than some peripheral town.


Firms who are part of a larger grouping will also be more receptive to new ideas, if any one member of the group adopts a new successful innovation, it is likely to spread to the rest of the group quickly. This is why you can get internet connection at any of the large chain of hotels regardless of where they are.


The Data

The analysis presented here is based on establishment level data held by the Office of National Statistics in the Annual Respondents Database (ARD).  It includes information on the number and location of individual establishments of multi-location firms.  There are a great number of firms in this survey which is done every year. Approximately 40,000 firms are surveyed each year.



Empirical findings


Findings of the analysis are reported in the paper. Here we summarise some results, not based on the paper but more recent results. Those in the paper will be similar. The figures reveal that when we simply take account of the size of the labour force employed by firms there are significant regional differences in productivity.  Relative to establishments in London those in Wales are 37% less productive, those in the S

South West 29% less productive and for those in the South East the gap is 14%[i]. 


However, taken together, the set of explanatory variables explains regional productivity differentials relative to London.  Statistically speaking, having added in these variables, there is no significant difference in productivity levels between the individual regions of Britain relative to London.  In terms of individual variables, capital stock per worker has a considerable impact on levels of productivity overall.  The proportion of the local labour force with high or medium level qualification both have a positive effect on productivity, although only high level qualifications (NVQ4 and above) are statistically significant at the 1% level. [A 1% significance level indicates that we are 99% the variable is significant in explaining productivity]


Ownership structure, more specifically multinational foreign ownership, clearly matters a lot.  Thus US multinationals are 7.9% more productive than the benchmark non US multinational firm, UK firms with parents 4.3% less productive than this benchmark and UK stand alone firms 15.6% less productive than this benchmark – taking into account the effects of all the other factors included in the model. Thus the productivity gap between US multinationals and British stand alone firms is approximately 28%, i.e. the former are some 28% more productive than the latter.


Establishments located in areas of higher population density are, however, more productive than others, taking into account the effect of all the other variables included in the model - although this finding is only marginally significant statistically speaking.  This provides some support for arguments based in new economic geography that clustering or agglomeration may have some effects on productivity.  Access to larger markets can bring scale economies.  Larger urban centres provide access to large pools of labour and human capital with a variety of skills.  They provide access to a wide range of subcontractors, suppliers and specialised services.  They also increase the possibilities of collaboration and interaction with other businesses and participation in networks and other forms of contacts, promoting both learning and innovation. 


Travel time to London also has a considerable effect on productivity – the longer the travel time to London the lower, on average, is productivity.  None of the other travel time or distance variables have a statistically significant effect. In addition when the journey times to four major cities [Nottingham, Manchester, Glasgow and Leeds] were included separately they were again insignificant.


In terms of industrial structure, productivity levels vary considerably across the different sectors.  Establishments in the catering sector are considerably less productive than in other sectors.  Establishments in the financial services sector are considerably more productive.  Differences in industry mix as such, however, have only a minor impact on overall regional productivity differentials (looking at the difference between columns two and three).  


Conclusions and Implications


There are clearly marked differentials in productivity across UK regions.  London has the highest level of productivity.  The initial gap between London and the other regions ranges from 37% in the case of Wales, and 32% for the North East down to 14% in the case of the South East.  These differentials can, however, be accounted for statistically by a combination of factors including differences in levels of capital per worker, hours worked (ratio of full to part-time staff), workforce qualifications, population density, industrial structure, ownership, travel time to London and the proportion of establishments offering web access (a proxy for adoption of innovative practices).  With the inclusion of this set of variables, regional productivity differentials are reduced to a level that is statistically insignificant.  Regional productivity differentials can be entirely accounted for, statistically, by a relatively small number of factors with a very plausible relationship to productivity. 


Table 2: Summary of Key Findings


In terms of policy implications we need to understand more the process of innovation and the adoption of best practice techniques. If our analysis is true and it takes time for this to spread out from London then how can policy makers intervene to speed up the process. How can we make, e.g. hotels in Cornwall as productive, as innovative as those in Canary Wharf?

Table 2: Summary of Key Findings


Initial productivity gap relative to London1


North West




North East


West Midlands






South West


East Midlands










Productivity differences by sector2












Real estate








Impact on GVAFC of:3


a 10% increase in Employment


a 10% increase in Capital


a 10% increase in % with NVQ4+


a 10% increase in % with medium qualifications


a 100% increase in population density


web access to outside users


a reduction in travel time to London from 90 minutes to 30


a reduction in travel time to London from 180 minutes to 30


a business being in the private sector




Productivity compared with stand alone firm3


US multinational


Non-US, Non-UK multinational


UK Parent








Barnes M. and Haskell J. (2000) Productivity in the 1990s: evidence from UK Plants Draft Paper, Queen Mary, University of London.


Bartelsman and Doms: Understanding Productivity: Lessons from Longitudinal Microdata, Journal of Economic Literature, 38(3), September 2000.


Cambridge Econometrics (2003) A Study on the Factors determining Regional Competitiveness in the EU, European Commission, Brussels.



Gardiner B. Martin R.  and Tyler P.  (2004) Competitiveness, productivity and economic growth across the European regions, Regional Studies 38, 1045-1067.


H M Treasury (2000) Productivity in the UK: 1 The Evidence and the Government’s Approach, HMSO, London


Office of National Statistics (2002) Annual Respondents Database, Office of National Statistics, London


Porter M. (2001a) Regions and the new economics of competition, in Scott, A.J. (Ed.) Global City Regions, pp. 139-152, Blackwell, Oxford.


Porter M. (2001b) Clusters of Innovation: Regional Foundations of US Competitiveness, Council on Competitiveness, Washington, DC.


Regional Studies (2004) Special Issue: Regional Competitiveness, 38.9.


Rice P.  and Venables A.  J.  (2004) Spatial determinants of productivity: Analysis for the regions of Great Britain, CEP discussion paper, 642.




As a Poastscript to the above the following illustrates similar effects of distance. This time on wages in urban China.


WAGES in China


So distance matters. But does it matter in other countries. Let us look at wages in China.


Private returns to education in urban China
Authors: Qiu, Tian; Hudson, John
Journal: Economic Change and Restructuring Year: 2010 Volume: 43 Issue: 2 Pages: 131-150 Provider: Springer


The analysis is based on the Mincer equation


LnY= β0 + β1EDU  + β2EXP  +   β3EXP2                                          (1)


Y is wages, EDU is years of education, EXP is years of experience, i.e. the time they have spent in the labour force.  Ln denotes the natural log. β0, β1 and β2 are the coefficients we need to estimate by regression. The idea behind the Mincer equation is that wages increase with both experience and education. The impact of experience is nonlinear. Hence the two eterms EXP and EXP2. β0 is a constant term. We can add other variables to the regression and this we do for variables reflecting region, distance from Beijing and Shanghai, gender and also what type of firm (e.g. state owned firm).


To summarize the findings,


Wages increase with education, and experience. They are lower for women (the negative sign on gender) but this gender gap is reduced by education (the positive coefficient on gender*education) so for women with degrees there is no gender gap, The negative sign on distance from Shanghai indicates that the further from Shanghai the lower the earnings. *** indicates this is very statistically significant. There are no *’s on distance from Beijing which indicates this does not matter all that matters in the Chinese context is distance from Shanghai. Once more, as with the productivity paper, distance is critical.


NOTE you are not expected to be able to interpret tables like this for this year’s exam. But for future reference in your second and final years, how do I know they are significant. This depends upon the t statistic [the figure in (.)]. A rough rule of thumb is if this is greater than 2.57 the variable is significant at the 1% level, >1.96 significant at the 5% level.



                          Table 3. Wages Returns to Education in Urban China                        



                                  1989        1993            1997       2000    All Four Years:

Variables                                                                                           OLS          Random Effects   Random Effects

Constant                    2.886***  2.986***    3.285***  2.526***    2.489***    2.588***           1.367***

                                  (14.19)     (9.35)          (10.73)     (6.64)          (16.67)       (16.69)               (6.50)     

Education                  0.367**    0.120***    0.143***   0.203***   0.115***     0.101***          0.224***               

                                  (1.97)       (4.16)           (5.25)        (6.58)          (8.66)          (7.53)                 (12.04)

Experience                 0.148***  0.115***    0.0911*** 0.0420*** 0.105***     0.101***          0.169***

                                  (20.84)    (9.55)           (8.04)         (2.85)         (19.33)       (17.57)               (17.33)

Experience²               -0.0027*** -0.0028*** -0.0019*** -0.0007** -0.0021*** -0.0021***       -0.0028***

                                  (20.63)    (13.13)         (8.21)          (2.46)        (21.08)        (19.40)              (21.06)

Gender                      -0.897*** -0.936***   -0.720***   -0.524*     -0.783***     -0.801***         -0.850***

                                  (6.36)        (4.26)          (2.92)           (1.91)       (7.11)            (6.72)               (7.68)

Gender*Education    0.073***  0.0606**    0.0573**    0.0496*    0.0626***     0.0621**          0.0689***

                                  (4.68)        (2.54)          (2.34)           (1.81)       (5.42)            (4.99)               (5.95)

Education*Experience                                                                                                                 -0.00370                        

Sector                                                                                                                                             (7,51)

      State                    0.727***   1.471***   2.619***      3.469***1.999***      1.722***         2.022***

                                  (4.58)        (6.16)          (8.79)           (8.98)       (15.99)        (14.15)              (16.08)

      State*Education  0.020       -0.0316        -0.138***    -0.0573    -0.0344***  -0.0185             -0.0402***

                                  (1.13)        (1.16)          (4.60)           (1.58)       (2.58)           (1.43)                (3.00)

      Private                 -2.012*** -0.8678**   -0.860***     2.480***-0.529***    -0.316**          -0.667***

                                  (11.30)      (2.52)         (2.63)           (5.53)       (3.54)           (2.28)                (4.47)

      Private*Education0.046**    -0.0852** -0.0621*      -0.145***  -0.0079     -0.0110             0.00251

                                  (1.99)          (2.04)        (1.72)           (3.09)       (0.45)            (0.68)               ((0.14)


      Liaoning/Heilongjiang-0.120  -1.033***  -0.648***    -2.408*** -2.828***   -0.678***          

                                       (0.961)  (5.27)        (3.80)          (10.76)      (13.72)             (7.74)  

      Shandong                        -0.3373***-0.812*** -0.837***   -1.617*** -0.4737***   -0.408***                                

                                    (2.60)          (4.25)        (5.40)          (6.74)        (5.45)             (4.13)

      Henan                  -0.4217***-1.501***  -1.055***-2.600***    -1.0993***      -0.983***

                                  (3.43)          (8.16)        (6.15)        (11.97)        (12.94)             (9.89)

      Hubei                   -0.7168***-1.024***  -0.558***-2.388***    -0.8848***      -0.887***

                                  (5.92)           (5.68)       (3.25)       (11.06)         (10.48)             (9.04)

      Hunan                  -0.7792*** -1.082*** -1.044*** -1.953***   -0.895***        -0.852***

                                  (6.20)          (5.87)        (6.78)        (8.75)          (10.71)             (8.78)

      Guangxi               -0.4335***  -0.735***-1.633***  -3.207*** -1.223***        -1.255***

                                  (3.61)          (3.99)        (10.18)     (15.26)        (14.86)             (13.43)

      Guizhou               -0.8503***  -1.316*** -1.920***  -2.945***-1.592***        -1.575***

                                  (6.92)         (6.73)         (11.27)       (14.53)      (18.93)             (16.54)

  Distance to Beijing                                                                                                                          0.000


  Distance to Shanghai                                                                                                                    -0.00159***


No. of the observations3207           2232      2629              2261      10325               10325          10325

Note: figures in parentheses (.) are t statistics. As a rough rule of thumb if > 2.57 then the coefficient is significant at the 1% level (marked ***), that is there is only a 1% chance the variable is not really impacting on wages. ** marks significance at the 5% level and * at the 1% level. A positive (and significant) coefficient means that as that variable increases so does the log of wages. Hence the more education the higher are wages. A negative coefficient has the opposite effect. Including both experience and experience squared produces a curve as shown below.


We have done a second paper on the Mincer curve:


This is based on


HERE the combined impact of experience depends upon parental education (Φ). The work is based on workers in the USA. The regression was such that the impact is as shown in the diagram below:



The more educated are your parents the more rapidly your earnings rise. But eventually the parental advantage declines. Presumably after 20 years in work people get paid on their merits not on advantages brought about by their parents. But do the curves cross as suggested above? Probably not we fitted linear segments (splines) instead of experience and experience squared. Previously people thought parents gave their children an advantage throughout their lives.



Why is distance critical? One reason is knowledge, knowledge diffusion and innovation.  Innovation and knowledge diffusion tends to first take place in large towns and cities. It then becomes diffused to other areas. Further Barriers include skill deficiencies which result in a low absorptive capacity of Low Income Country domestic firms and communication barriers. Restricted social networks, which often involve people from the same social strata, limits interaction and knowledge diffusion between firms. Between countries, networks, e.g. of business or scientists, facilitate knowledge diffusion. In both developing and developed countries Finance and Mismatch also limit knowledge diffusion, Some knowledge costs a firm to acquire, particularly if it is protected by IPRs and/or needs to be licensed. This is the negative impact of IPRs. Technology developed in developed countries is often inappropriate to the needs of the LICs, where it will need considerable adaptation.


Facilitators of knowledge transfer include the universities, multinationals (i.e. FDI) and trade and standards, They facilitate knowledge transfer by reducing one or more barriers. However, there are problems in that these facilitators are not as effective as they might be. For example, the Universities in the North are increasingly expected to extend the traditional functions of basic research to technology development and entrepreneurship. It has been argued that LICs are best involved in adaption rather than innovation, but with limited technical resources in firms, universities in the South still have an important potential role to play in absorbing new knowledge from around the world and transferring and adapting that knowledge to firms within the country. However, with the partial exception of agriculture, there is a failure to link researchers to other agents in the innovation process, particularly firms and end users.


Multinationals could do more in terms of knowledge transfer within the countries they locate and pressure should perhaps be put on them to do so. The evidence suggests they are reluctant to use local firms for anything but low value activity and reluctant to transfer knowledge where there are weak intellectual property rights IPRs (e.g. patents). However, there is some disagreement upon whether strong IPRs benefit developing countries. The OECD has argued that patents are particularly important for new, small firms (startups) which have no other means of protecting their inventions. Much of the theoretical work supports the hypothesis of a positive impact on LIC innovation. However, patents particularly for LICs, who are not generating a significant number of global patents, may be more of a potential barrier in increasing the cost of acquiring new technology.


For standards see:


Final thought, innovation can occur in unexpected ways and need not be the result of large scale R&D.


Mobile phones and the further innovations they facilitated.


The graph shows that in LICs the rate of take up has been very substantial particularly since 2005 and they are beginning to approach the poorer middle income countries in this respect. The success of mobile phones has not depended on a specific policy initiative on the part of donors or developing country governments to promote uptake of the technology. Although it can be hampered by poor regulatory and anti-competition policies (Gao and Rafiq, 2009) as in Ethiopia  where a state owned monopoly owns all forms of communication (Essebar and Stark, 2005). However, with more complicated technologies such as broadband, governments can have a substantial positive impact. In Korea, e.g., policies included IT literacy and Internet literacy programmes targeted at particular populations such as housewives, the elderly, military personnel, farmers and socially excluded sectors such as low income families and the disabled (Choudrie et al. 2003)


Mobile telephones have been critical in reducing the disadvantage of distance and has led to further innovations:

Mobiles for farming – New services such as AppLab, run by the Grameen Foundation in partnership with Google and the provider MTN Uganda, are allowing farmers to get tailored, speedy answers to their questions. It has been expanded to Uganda, Indonesia and Ghana. It has also extended to fishing as in for example in Kerala where mobile phones were introduced in 1997. Fishermen use the phones while still at sea to find out the prices in different markets. They even negotiate a sale whilst still at sea. Within a few weeks this significantly reduced the dispersion in fish prices between markets and raised the average profits of fishermen by 9% (Divakaran et al. 2007). A scheme is being developed to text farmers in the Philippines, messages with advice on how to grow their rice. The scheme will provide advice on topics such as what type of fertiliser to use - and how much, provided by local scientists.

M-Banking Mobile banking systems allow users to convert cash in and out of ‘stored value’ accounts linked to their mobile phone, use the stored value to pay for goods, and even transfer stored value between their own and other people’s accounts. A variety of successful initiatives are now running in South Africa, Kenya and the Philippines. In Kenya, mobile phones allow users to send money inside the country to owners of other mobile phones. The system has attracted over 5 million consumers in less than two years in a country where only 26% of the population has a bank account (OECD, 2010). Similar projects have been announced in 10 Sub-Saharan and in three North African countries.








This is the most important economic event for a generation. Quite possibly it will prove the most important crisis of your life.


The immediate source of the problem lay with the US sub prime mortgage market. Americans who were not good credit risks were being given mortgages often close to 100% of the value of the property. Rising energy prices began to slow the US economy and as result people began to default on their mortgages. Now with rising house prices this would not have been a problem to the banks. But house prices actually began to fall and that meant that banks could not recover the full value of their loans – an example of so called toxic debt. Again this should have been a problem for the US, but not for the rest of the World. These were US bad debts why should they impact on the EU directly? We turn to this question later. But first why did house prices begin to fall? The answer lies with the fact that they were too high, driven by irrational exuberance. The figure below shows the climb in US house prices – in parts of the country, e.g. the West Coast the increase was much greater. This rapid rise is in itself not a problem, it could reflect inflation. More telling is the ratio to GDP. The second figure shows the rapid rise from the end of the 1990s until by 2006 relative to GDP it was the highest for the period our data covers. Since then it has fallen rapidly, perhaps too much and is now the lowest ratio there has been.







In the UK we get a similar picture. House prices have risen rapidly with a glitch reflecting the 1991 house price crisis. The ratio to GDP is again more illuminating. The 1991 housing bubble is clearly illuminated as is the fact that it took several years to recover from this. But as a bubble it bears no resemblance to what we have seen since the end of the 1990s. The ratio of house prices is still way out of line, indicating that they are too expensive for people to really afford. Thus the evidence is that the UK would have gone into recession without any help from the US sub prime market crisis. The UK had its own crisis; put the two together and we begin to move into serious even unprecedented times. What is more it would appear that UK house prices still have some way to fall. They are not, they have not and one is left in a quandary. When will this happen? Will it happen? answer to the last at least: Very likely.





But back to the question why did a crisis which should have been limited to the US engulf the World? This is linked to developments in finance. Different financial instruments, loans to businesses, mortgages are aggregated and then sold. Hedge funds may take the riskiest, pension funds less risky and so on. They have sophisticated names: ‘mortgage backed securities, collaterised debt obligations (CDOs) and asset backed commercial paper (ABCP). The theory behind this is in part that one risky asset with a probability of default of 10% is risky, but a thousand are not, you know that 10% will go bad, you charge 20% interest, you make a profit.


This rests on the assumption that if the risk of two assets A and B defaulting is 10% the risk of both of them defaulting is 0.1x0.1= 1%. That is the probabilities are separate, if A defaults it has no implications on the probability of B defaulting.


The theory falls down however, because of systemic risk, i.e. the housing market and economic collapse which means that yes the chance of a debt going bad is 10%, but if it does then the chance of other debts going bad is then much greater than 10%. The probabilities are not independent. There are two reasons a debt may go bad, something unique to that debt or that locality (e.g. a drought affects part of California). Or factors which affect all debts – systemic factors.


The parcelling together of debts made it difficult for banks to evaluate their risk. Banks were not holding 1 asset at a time, but a bundle of assets. Thus a bank in London is holding potentially toxic assets consisting of mortgages in Tennessee, Los Angeles and Bradford. In selling the debt on in this way, the people who hold the debt are removed from the local realities relating to that debt.  Now if Bank A itself does not know the extent of its own exposure to bad debt, how can anyone else including other banks have confidence in Bank A? They cannot and at this time banks stopped lending to each other and banks unsure of their own financial position reduced lending, particularly unsecured lending, to all. The LIBOR, the inter-bank lending rate, the rate they lend to each other increased dramatically.


In my view, and this is something the regulators have not begun to approach, if a local bank makes a loan it should keep that loan, not sell it on. The local bank knows local conditions. A bank thousand of miles away does not. That is just one of the pieces of the regulatory jigsaw which needs to be fixed.



The bundling of consumer loans and home mortgages into packages of securities is known as securitization. More than $27 trillion of these securities have been sold from 2001 to 2009. That's almost twice last year's U.S. gross domestic product of $13.8 trillion.


The growth over the past decade was made possible by overseas banks, which saw the profits U.S. financial institutions and wanted similar. European banks, in particular, were eager adopters. Securitizations in Europe increased almost sixfold between 2000 and 2007, from 78 billion euros ($98 billion) to 453 billion euros.


Three Icelandic banks borrowed enough to buy $228 billion of assets, most of them securitizations, turning the country's financial system into a hedge fund.


``Securitization was based on the premise that a fool was born every minute,'' Joseph Stiglitz, a professor of economics [and Nobel prize winner] at Columbia University in New York, told a congressional committee on Oct. 21. ``Globalization meant that there was a global landscape on which they could search for those fools -- and they found them everywhere.''



It would be wrong to think that the problems were restricted to financial institutions in the US, primarily the UK linked to the sub-prime market. Hence many Hungarians obtained mortgages denominated in Euros, when the Forint fell against the Euro, they met grave problems. In Iceland the countries banks owed around six times the country’s GDP. When credit dried up they were unable to refinance loans.



THE CAUSES SUMMARY [For more details see the time line of events]


1. Years of continuous boom during the 1990s, low interest rates and irresponsible lending [mortgages at 100% or more to poor risks, i.e. people who were at substantial risk of defaulting) triggered a house price boom in USA.


2.  The Federal Reserve concerned about the house price bubble increased interest rates. This plus the slowing of the economy brought about in part by higher energy prices led to a slowdown in the housing market an increase in people not being able to repay their mortgages. The banks then tried to recover their assets by repossessing the home and reselling it. But falling house prices meant they did not recover all their money – toxic debts.


3. These toxic debts were not limited to US financial institutions. The original mortgage given by bank A had been sold to bank B. Bank B had combined it with other ‘financial instruments’ (i.e. other mortgages, loans, and so on) in a financial package and sold to a different bank C, who further sold it on. Thus this original mortgage of a poor American family in Tennessee  ends up in the hands of a bank M in London, Paris or Switzerland.   Bank M has assets it has little idea about their credit worthiness, little idea about how much they are worth, how much toxic debt it is holding. Because they have little idea other banks will not lend to them to interbank rate soars to new heights.


4. Banks experience severe financial difficulties and governments across the World need to step in with rescue packages, draining money from the public finances.


5. Falling house prices, rising energy prices by themselves would slow consumer spending [the first denotes a cut in people’s wealth, the second a cut in their real income]. This would then have multiplier effects on the rest of the economy. This would have happened in the UK anyway because we had our own housing price bubble. But the credit crisis as it has become means banks have severely curtailed lending, lending on new mortgages, lending to firms, lending to consumers. Consumers expenditure is cut still further. Firms concerned with cash flow and their financial situation cut back on investment, other firms who want to invest cannot get money from banks. Investment falls with more multiplier effects cutting GDP. Particularly hard hit are consumer durables, including cars, and the construction industry. Falling GDP, leads to rising unemployment. Consumers worried about the possibility of losing their job cut back still further.


6. All of this was compounded by stupidity in other countries. In Hungary people took out mortgages in Euros from European banks. The Forint falls against the Euro they can no longer afford the repayments. In Iceland the countries banks owed around six times the country’s GDP. When credit dried up they were unable to refinance loans.


This only adds to the World’s economic problems, but with Iceland too, as many people, local authorities had money with Icelandic banks. The whole world is suffering a downturn and that means that the  UK’s exports decline and yes the multiplier gets to work again.


7. We would have had recession anyway with our own housing price bubble which had to burst. But the credit crisis linked to toxic debts in the US sub prime market made it worse, made a recession a global disaster.  As well as concerns over the economy, there were concerns over the financial system and if it would crash. If in the UK one major bank had gone bankrupt with customers losing money, that would have ended confidence in the banks for a generation or more. This is what the government, governments everywhere, were so concerned with.


8. But if I was to blame the crisis on one thing it would be a lack of regulation, and one more, people forgot booms do not last forever.



But there will always be fools who believe they can walk on water. It is the job of the regulatory system, not to stop them drowning, but to stop the rest of us going down with them. Regulation failed, failed to control the excesses of the banks. This is not just a failure of a system and procedures. It is a failure of people. Whole masses of people, major people, in the regulatory system should resign, if not at once then over the next five years and without substantial pensions. They have failed.




The figures below show the course of interest rates in the US and UK. The unprecedented levels of US interest rates are clearly shown. For the UK interest rates are now lower than at any time since the Bank of England was founded in 1695.


But what is also shown is what appears an inappropriate policy response in 2005 when interest rates rose sharply. This was partly in response to fears about house prices and the sub prime market. Low interest rates prior to that had been partly responsible for driving house market prices up and the increase in interest rates helped bring this to an end. Hence there look in retrospect to be two errors, firstly the sharp drop in interest rates in the early part of this decade which helped drive the surge in house prices and secondly the surge in interest rates which arguably, but only arguably, was too sudden and precipitated the crisis.


Perhaps what should have been done is an interest rate increase to spike the house price bubble, but once spiked, an immediate decline in interest rates to help firms in ‘the real economy’. But in this respect hindsight is a fine thing. What is however unforgiveable is the inaction which let the house price bubble rise so far, and the inaction which failed to regulate financial markets which had become seriously out of control.







Recession tracker [Source BBC website]



Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Bank of England - Interest rates, 1694-2009


For an optimistic view on the UK:


The other aspect of this has been: an increase in the money supply and also increased borrowing both to provide a fiscal stimulus to the real economy and help the financial sector, the banking sector. For the UK at least all of this has led to concerns with the economy and as a consequence the pound has begun to fall. This has had the effect of a devaluation and for example the UK tourist industry in 2009 had a good year.


Huge, mind boggling, sums of money are involved, but this is not all or even mostly in terms of the fiscal stimulus. Some is, e.g. China announced in November 2008 a $586bn economic stimulus package focused on investment in infrastructure and social projects as well as corporate tax cuts. Also in November 2008 the European Commission presented a 200bn  Euros package aimed at stimulating saving and boosting confidence. But in the UK and the USA much of the money went not on a fiscal stimulus per se but aiding the financial system and helping loss making firms.


A Return to Keynesianism?

It might be thought of and as indicated is considered as a classic case of Keynesian fiscal policy. But is it? Keynesian fiscal policy is used to fill an output gap. In part this is what the fiscal stimulus is designed to do, but much of the government borrowing, much of the increase in the money supply, termed quantitative easing, is aimed at rescuing the financial system, stopping banks going bankrupt, defaulting on deposits as if such a thing were to happen to would totally destroy confidence in the banks by ordinary members of the public for a generation or more. But this is not classic Keynesian fiscal policy and I am not certain whether Keynes or leading Keynesians from the past would have approved of using public money raised by borrowing and printing money to rescue the financial system at a time of economic crisis, rather than letting some banks go bankrupt, possibly nationalising them in the process, whilst protecting depositors.


The Regulatory Response: Reform 1.ppt


A Changing World Architecture

One of the consequences of the crisis is that it will result in substantial changes in the administrative, regulatory systems across the World and also in international institutions. Some of these are already becoming apparent, others are less clear and will evolve over time. They include:


·              Increased international co-operation. The problem with this is that the US and UK are likely to remain reluctant. But regulation will come:


·              The G7 largely replaced by the G20 (i.e. more nationals are now seated at the international table).

·              Enhanced role and funding for the IMF


·              The decline of the $ as THE reserve currency, initially to be joined by the Euro, but China is talking about using SDRs as a reserve currency which would give even greater power to the IMF. The problem with this is that the Euro too is now caught up in its own crisis.

·              The relative decline of the USA and the rise of the East, the Middle East and the Asian economies (Japan?, an Asian economy with Western characteristics)

·              The end of unregulated free market capitalism as a model for the World to follow. But will the World coalesce around another model? Or will some countries, mainly the USA and UK cling to a form of unregulated capitalism, whilst others, particularly the rest of the EU move even closer towards regulated capitalism. If two systems co-exist where does that leave globalisation. If there are two different systems for regulating banks which will global banks seek to satisfy? The answer is probably the stricter EU model, as to trade in the EU they will have to meet EU regulation and this should automatically satisfy laxer US legislation. However, there are signs that the Obama administration is taking regulation more seriously than previous US administrations.




·              Salary caps to make impossible the enormously high salaries paid to some people particularly in finance?


·              The (part) nationalisation of the banking industry


·              Increasing international co-operation. It is also clear that there is more economic co-operation than ever before forced once again on governments by the crisis and the global and interrelated nature of the crisis. No one country can act alone to ‘solve’ the crisis. It requires e..g. international regulation of banks who are essential international concerns. Monetary even fiscal policy is also being increasingly co-ordinated. The role of governments is beginning to be a committee member on international committees. On a regional scale this is becoming even more obvious with the clearest example being the EU. 


The point is that all these changes are happening so fast that no one is sure where it will take us. Change is being forced on the global economy, not steady planned rational change, but change in a response to necessity. In five years time the world will be a different place to now. We are just not sure how.


The UK’s Problems


The cost of the fiscal expansion a large debt and rising uncertainty



The fear is that the UK’s credit rating will fall forcing us to pay much more when we borrow to finance that debt. We are not in Greece’s position, nor anywhere near it. But the shadow of Greece hangs over the UK’s public deficit and indeed that of the other countries too and one of these days the situation is Japan will escalate to crisis.


One problem leads to another. OK we are ‘solving’ today’s problems with mechanisms like quantitative easing, increased borrowing. Lets move forward two years. Recession has come to an end. The US and UK economies are not growing that much but have stopped declining. But both have rapidly expanded the money supply. Both have   borrowed enormously. The first will probably lead to inflation. The second means the money will have to be paid back. Higher taxes lower government spending. This will slow any recovery, lower living standards for several years at least in both countries. For the US it will almost certainly be forced to reign in expenditure including on the military which has been one the pillars of its power base in the world. As for the UK; it “ has nothing to sell”; Jim Rogers co-founder of the Quantum Fund with George Soros


      The North Sea is one of the fastest-declining oil provinces in the world. The peak of oil and gas production came at the turn of the decade. Since 2002 output has been falling at an average rate of 7.5 per cent a year. If no new fields are developed, it has been estimated that the North Sea will be, in effect, finished by 2020, after a further 7bn barrels of oil equivalent [boe] have been extracted. With sustained investment, and some further discoveries, the rate of decline could be slowed to 4-6 per cent a year, and a further 15bn-18bn boe ex-tracted, keeping the North Sea alive until about 2040.


      For the UK the credit crisis may also have done long term damage to the City of London as a financial centre. The main logic for that position now we no longer have Empire is/was based on ‘expertise’. As with the US that prestige has been dented. In addition London was attractive because of low regulation. That attraction too has gone.


      We have run down manufacturing so now it is only one sixth of the UK economy, but over half of its exports. However, it has been in decline for decades and although well placed to export to ‘the World’, it is badly placed to export to Europe and we are losing out at the moment to low cost centres in Central and Eastern Europe, but also the developing world.


      The UK will have to reinvent itself. A reinvention in my view based on investment, investment in human capital (our people), investment in infrastructure, investment in R&D and high tec products. But its not easy.




Quantitative Easing


Actually that may not work, Try doing a search on Google typing:

ft quantitative easing giles Cynthia

and then click on the link


The sums involved are startling. At the end of its third round of asset purchases, the BoE will own £325bn of financial assets, predominantly government bonds (or gilts), which it will have bought with newly created money. This £325bn is after purchases of £50bn in February and £75bn in October It will own close to a third of the gilt market. Gilts (Gilt-edged securities) are bonds issued by certain national governments, in this case the UK government. 


Bonds are a debt security. The issuer (e.g. the UK government) owes the holders (often banks) a debt and, depending on the terms of the bond, is obliged to pay interest to the holder and eventually repay the debt in full. Bonds are for different lengths of time. 5 years, 10 years even 50 years.

The US Federal Reserve held between $700 billion and $800 billion of Treasury notes on its balance sheet before the recession. In late November 2008, the Fed started buying $600 billion in mortgaged backed securities (MBS). By March 2009, it held $1.75 trillion of bank debt, MBS, and government debt, and reached a peak of $2.1 trillion in June 2010. In November 2010, the Fed announced a second round of quantitative easing, or "QE2", buying $600 billion of government debt by the end of the second quarter of 2011. The markets and the World are waiting for QE3. To put this in perspective the US economy was just over $15 trillion in 2011. Hence this printing of money is a sizeable portion of the US economy.

The UK and the US are doing this partly for the reasons outlined in the talks – keeping interest rates low, diverting funds to firms etc. But too they are buying the debt directly, or indirectly, of government. Governments are running a deficit and part, a large part of that deficit is being financed by the Central Bank printing money (sorry to all those who say its not printing money, that in a real sense is what it is). Now in times gone by most economists would have been appalled by that and would have argued that on the scale it is being done it will lead to inflation. After all if its such a great idea why did we not do it before?

Has it worked?

The following is based on a piece in the Wall Street Journal. They point out the economy is barely moving and inflation is above target. Domestic bank lending has fallen continuously since March 2009 while lending to small and medium-sized businesses shrank by close to 7% in the year to November 2011. Meanwhile borrowing rates for businesses still haven't come down, while last week two of the U.K.'s biggest lenders actually increased mortgage rates by 0.5 percentage points. The BOE approach has supported government borrowing while putting maximum pressure on banks—and businesses and households that rely on them—to pay down debt. Despite  what the film clips say, the BOE's strategy has been deliberately designed to try to bypass the banking system, buying bonds direct from government. The Monetary Policy Committee have argued that their version of QE has pushed investors out of gilts into other risky assets, improving market liquidity and reducing the cost of borrowing in corporate bond markets. The BOE calculates QE boosted GDP by up to 2.5%, while increasing inflation by up to 1.5%. At the same time, BOE officials are particularly sensitive of criticism of their decision to buy gilts rather than private sector assets from banks.

But, the Wall Street Journal argues, it has had no obvious impact on the cost of bank lending, which remains far above the BOE's official interest rate of 0.5%. That's hardly surprising when everything else the U.K. regulatory authorities are doing seems calculated to raise the cost and restrict the availability of bank lending. U.K. banks face some of the toughest capital and liquidity rules in the world which have helped drive down returns on bank equity well below their cost of capital. At the same time, the U.K. banking system still faces a huge funding gap, given its historic reliance on wholesale funding (as  opposed to funding from ordinary depositors/savers). Market leader Lloyds Banking Group is offering more than 4.5% interest on five-year savings accounts, forcing other deposit-hungry banks to raise rates. These costs get passed on to customers.



To add to the pressure on the BOE, the European Central Bank has taken a markedly different approach: It is pumping money into the economy by supplying the funds directly to the banking system via the offer of unlimited cheap three-year loans to banks, whereas the BOE's strategy has been deliberately designed to try to bypass the banking system.

[Note: At the micro-level, deleveraging refers to the reduction of proportion of for a firm or household. It is the opposite of leverage. At the macro level deleveraging of an economy refers to the simultaneous reduction of debt levels in multiple sectors It can be measured by the decline of the total debt to GDP.]

 That reflects a fundamental philosophical difference. The ECB approach is designed to slow the pace of bank deleveraging, thereby providing scope for governments to put their finances in order.

The ECB's balance sheet has topped 3 trillion euros as it bought government bonds of countries caught in the debt crisis and loaned a trillion euros in long-term liquidity to the banking system. Note the ECBs actions have been aimed at propping up weak governments such as Greece and also propping up weak banks who may be weak because they have lent money to the weak governments and in the case of Greece saw a loss as Greece defaulted on its debt.

How did the ECB provide money to the banking system? Through a three-year long-term refinancing operation, or LTRO. A total of 800 banks borrowed money, in the latest round of bank lending in February 2012 when 530 billion euros was made available. The idea is to counter frozen interbank lending and dampen tensions on euro zone bond markets. It is also hoped that the banks will give money to creditors, firms e.g.. In an earlier phase of this however the evidence is that the money went for other purposes, e.g. buying up government debt. For example, Intesa Sanpaolo, Italy's biggest retail bank, took 24 billion euros of the money handed out and said part of the cash would be used to buy Italian government bonds.

Nonetheless, Standard & Poor's said the ECB funding measures had reduced the risk of liquidity driven bank failure and averted a severe credit crunch in the euro zone. Despite this they considered that the ECB's actions did not address the underlying structural issues in the banking sector, citing capital shortfalls at some banks and some questionable business models. But what happens in 3 years time when they have to be repaid. Will the ECB lend again? Will this become a permanent feature of central bank activity and in the light of the crisis does it represent an extension to the role of central banks? Or will the banks have to pay it all back. And then? There is also the worry that other banks and financial institutions will not lend to banks with LTROs. In the event they go bankrupt, ECB  debt is senior to other debt, they will be paid first. All of this could be beginning to fundamentally changing the way bond markets and more generally money markets work. In a sense its linked to the Lucas critique (see and elsewhere in these notes). More simply it can be thought of as the law of unintended consequences. Policy innovations often change the world in ways which take us by surprise and which are not always welcome.

We had LTROs before the current round before 2011, but these were generally for less than 3 years:





We can see the impact of the crisis on credit by the sharp drop in M3 and loans to private sector. This is why M1 has been increased sharply at a time of low inflation, although its impact on credit has been limited. Its why too inflation has been so far muted in response to QE. This has been the case in the UK too. BUT what if banks suddenly start lending as before. Use the money base as a basis to give credit to customers as they used to do. Then there  is the potential for M3 to expand rapidly and surely then inflation will become really serious.




But in the UK QE has not been getting into the system neither M1 nor M3. Presumably this is because of its focus on buying government bonds. Interesting.

IMPORTANT: For quantitative easing see:


Note: I tend to think the above is both complacent and misleading. In many countries including US and UK quantitative easing is being used to buy government debt as well as, or even more than, going to help firms. This is also the case with the European Central Bank who lend newly created money to banks in say Spain and Italy who then go and buy government debt. Also:


For the summer holidays to read an overview on the crisis:


The Euro crisis (and Quantitavive easing). We will focus on Greece as an example. But the story is similar for several other European countries.  Prior to joining the Euro Greece’s finances were precarious. Once it joined the Euro it had access to cheap loans on the international money markets. Public spending increased rapidly and public sector wages practically doubled. To an extent this was kept out of site by a series of measures of creative accounting. When the downturn happened borrowing increased still more. Eventually it became apparent that Greece was struggling to repay its debts (bonds whose maturity date had been reached meaning they had to be repaid. The obvious solution would be for Greece to leave the Euro, even if only temporarily, devalue its currency, default on its loans and try to implement political reforms which would make it a viable country. That did not happen. It was given 110bn euros of bailout loans in May 2010 to help it get through the crisis - and then in July 2011 it was earmarked to receive another 109bn euros. But that still was not considered enough. In October 2011, the Eurozone asked banks to agree to a 50% "haircut" [loss] on their Greek holdings, alongside an enhanced 130bn-euro bailout. There were more loans in 2012 and a bigger haircut. To all intents and purposes Greece had defaulted on much of its debt. Finally this became official and triggered credit default swaps (insurance policies bond holders take out in the event of default). In return Greece is being asked to pursue severe deflationary policies with large scale cuts in government spending. The result is rioting on the streets, a severe recession, little prospect of growth in the immediate future and substantial outward migration. Many people are leaving Greece, and probably the best of their people. Hence the debt burden is being shared between fewer and fewer people. Is this sustainable in the long run? I do not believe so. There will soon be a Greek election and that may trigger a Greek exit from the Eurozone. Other Eurozone countries are unhappy at the favourable (e.g. low interest rates on loans) that Greece is getting. Other countries are in any case facing similar problems. The Euro crisis is not over.

The Future:

Thus the crisis in 2008 led to a situation where governments were forced to bail out the financial system and as a result run up a considerable amount of borrowing. The recession brought about by the crisis led to a reduction in tax revenue also driving up borrowing. The net effect is that debt to GDP ratios increased dramatically. Governments were finding it increasingly difficult to borrow money at low rates of interest. The banks who were told to restore their balance sheets substantially reduced lending to everyone but especially small firms and households. QE was to solve both these problems. But if printing money (and it WAS and IS printing money) is such a great idea why not do it ten years ago? The story is far from over. The crisis is far from finished. The EU may split. The Eurozone will almost certainly change, be smaller but more politically unified (and then the countries which remain in will form an inner EU core).

Greece has an election within weeks. They may then leave the Eurozone. France too has an election and if the socialists win they will seek changes, changes which may strain the  Franco-German alliance which has been at the heart of Europe for 60 years.  The US faces political paralysis. The republicans don’t want to raise taxes. The democrats don’t want to cut welfare spending and both are reluctant to cut military spending. The UK is going in for creative accounting to bring the debt down (but they all are). The story is far from over.

In any case I believe all this is missing the point. Quantitative easing is at best a short term solution. The loans to Greece are short term. Long term solutions lie in getting the economies growing and this means the EU and the UK need to produce products the world wants to buy the secret is innovation. The US takes innovation seriously e.g. Silicon Valley. Most of Europe pays it lip service as does the UK. The EU spends more, much much more on agriculture  than on innovation. That is not a recipe for success. In Greece the main problem is corruption and tax evasion. Corruption deters innovation and if the Greeks had the same level of tax evasion as the Scandinavians there would be no crisis. These views are expanded in a lecture I gave at the Czech Central Bank in late 2011: to Basics.ppt



The IMF on ‘the Great Recession’

Below is the IMF’s home page:


See this video


In 2010, world output is expected to rise by about 4¼ percent, following a ½ percent contraction in 2009. Economies that are off to a strong start are likely to

remain in the lead, as growth in others is held back by lasting damage to financial sectors and household balance sheets. Activity remains dependent on highly

accommodative macroeconomic policies and is subject to downside risks, as fiscal fragilities have come to thefore.


 In most advanced economies, fiscal and monetary policies should maintain a supportive thrust in 2010to sustain growth and employment. But many of these

economies also need to urgently adopt credible medium term strategies to contain public debt and later bring it down to more prudent levels. Financial sector repair

and reform are additional high-priority requirements. Many emerging economies are again growing rapidly and a number have begun to moderate their accommodative

macroeconomic policies in the face of high capital inflows.



During the Great Recession, output and unemployment responses differed markedly across advanced economies (Figure 3.1). For example, in Ireland and Spain the unemployment rate increased by about 7½ percentage points, despite the fact

that output dropped by more than 8 percent in Ireland but by only half as much in Spain. Moreover, although Germany suffered an output drop of about 7 percent, its unemployment rate actually decreased. Such different responses suggest that, apart from the impact of output fluctuations, unemployment dynamics are also driven by institutions, policies, and shocks.


The responsiveness of unemployment to output has increased over the past 20 years in many countries. This reflects significant institutional reform, particularly making employment protection legislation (EPL) less strict, and greater use of temporary employment contracts.


During the Great Recession, the sharp increases in unemployment in Spain and the United States can be explained largely by the impact of output declines as predicted using Okun’s law, by financial stress, and by the impact of house price busts. In countries that implemented large short-time work programs (Germany, Italy, Japan, Netherlands), the rise in unemployment was less than predicted by these factors. Other countries that experienced less unemployment than expected present more of a puzzle (Canada, United Kingdom).





From Lecture Notes given in 2010: The Greek Dimension


The crisis has now taken on a new dimension. The fear that countries may go bankrupt. Most obviously there is Greece, but in Europe alone there is also Ireland, Portugal and even Spain and Italy. All members of the Eurozone.


[Taken from the BBC] Its government owes about 300bn euros ($400bn; £260bn) and has to pay off part of that next month. Greece has formally asked the European Union and the International Monetary Fund (IMF) for financial assistance to help the country out of its debt crisis.  Global stock markets fell after ratings agency S&P downgraded Greek debt to "junk", which means it views Greece as a highly risky place to invest.


The Greek government has been irresponsible in recent years. Public spending has increased substantially, along with public sector wages and social benefits. At the same time widespread tax evasion has hit revenue. Greece's budget deficit, the amount its public spending exceeds its revenues from taxation, last year was 13.6% of its gross domestic product (GDP). This is more than four times the limit under Eurozone rules.  Greece's high levels of debt mean investors are wary of lending it more money, and demand a higher premium for doing so.

This is a particular problem this year as it must refinance more than 50bn Euros in debt this year. The country is asking for as much as 45bn euros in emergency loans from eurozone governments and the IMF this year.


Is this a new problem or part of the old one? Well the recession would have hit Greece badly, lower tourism lower demand for its exports reducing taxation and as elsewhere necessitating higher government spending. Greece’s problems are more fundamental, but again reflect a highly irresponsible attitude to finance which characterised the banking system in the USA and the UK.


What will happen?


In my view Greece is likely to default on the debt and then exit from the Euro. It will of course then be unable to borrow money on the international money markets in the future for probably decades to come. Pressure will then turn on other weak countries. It is this fear of contagion that is forcing the EU and the IMF to try to rescue Greece. But the problem here is hat it is not just Greece they will have to rescue.  As for the Eurozone itself, a newer slimmed down Eurozone with fewer countries will have to resolve the problem that you cannot have a single currency without much tighter fiscal control over the member countries than in the past.


Note that, you will not find that many economists saying this. But I strongly believe the job of the economist is to read the runes, look at the evidence, use their knowledge of economic theory and say given this, then this is likely to happen. But always use the word ‘likely’. We live in an uncertain world.




In future years the critical event in this will be seen, rightly or wrongly, to be the demise of Lehman Brothers.



Perhaps the first sign of the crisis came In April 2007 when New Century Financial, which specialises in sub-prime mortgages, files for Chapter 11 bankruptcy protection. But people began to wake up to its potential seriousness in August 2007 when Investment bank BNP Paribas tells investors they will not be able to take money out of two of its funds because it cannot value the assets in them, owing to a "complete evaporation of liquidity" in the market. The European Central Bank pumps over 200bn euros (£63bn) into the banking market to try to improve liquidity .





In February the realisation that this is no ordinary crisis gathers pace with the nationalisation of the first major bank, the UK’s Northern Rock on 17th February. A month later Wall Street's fifth-largest bank, Bear Stearns, is acquired by larger rival JP Morgan Chase for $240m in a deal backed by $30bn of central bank loans. Just a year earlier, Bear Stearns had been worth £18bn.


In mid July the US, the financial authorities have to take action to save America's two largest lenders, Fannie Mae and Freddie Mac. It is all to no avail and in   September they are rescued by the US government in one of the largest bailouts in US history. Treasury Secretary Henry Paulson says the two firms' debt levels posed a "systemic risk" to financial stability. Together they account for nearly half of the outstanding mortgages in the US and either own or guarantee $5 trillion worth of home loans. 


Having bailed out two large financial institutions the US government baulked at rescuing a third, and on 15th September the Wall Street bank Lehman Brothers filed for Chapter 11 bankruptcy after posting a loss of $3.9bn for the three months to August. A second US bank Merrill Lynch is taken over by the Bank of America for $50bn. The US Federal Reserve announces an $85bn rescue package for AIG, the country's biggest insurance company, to save it from bankruptcy. AIG gets the loan in return for an 80% stake in the firm.


In the UK, on the 17th September Lloyds TSB announces its intention to take over HBOS. Just over a week later Fortis, the Dutch banking and insurance giant is partly nationalised.  The list is almost endless, before the month is out the UK nationalised the mortgage lender, Bradford and Bingley sellings its savings operations and branches the the Spanish Bank Santander. The Icelandic government and the Belgian, French and Luxembourg governments commit to putting in 6.4bn Euros into Dexia


8 October

The UK government announces details of a rescue package for the banking system worth at least £50bn ($88bn). The US Federal Reserve, European Central Bank (ECB), Bank of England, and the central banks of Canada, Sweden and Switzerland make emergency interest rate cuts of half a percentage point.


13 October

The UK government announces plans to inject a total of £37bn into Royal Bank of Scotland (RBS), Lloyds TSB and HBOS. The takeover of troubled US bank Wachovia by Well Fargo is approved by regulators.


 14 October

The US government unveils a $250bn (£143bn) plan to purchase stakes in a wide variety of banks.


30 October

The Federal Reserve cuts its key interest rate from 1.5% to 1%.




The New Constitution [Not for 2012]

Throughout the course people have been asking me about the Euro and the Constitution. The following is an extract from a presentation I recently gave. It looks at the issues. BUT IT IS FOR INTEREST ONLY. I do not expect you to learn this for the exam. In addition it has not been updated for 2010

 “Gentleman, you are trying to negotiate something you will never be able to negotiate. But if negotiated it will not be ratified. And if ratified it will not work.” British Representative, in 1950s at negotiations to set up EEC.


The single currency has “all the quaintness of a rain dance and about the same potency”. John Major, 1993.

With the expansion of Europe to 25 member states it was clear that a new way of doing things was required, clearly e.g. a blocking vote by any one state is no longer a viable option. In some countries, notably Britain, there will have to be a referendum. In others, parliaments will ratify the treaty, or not. If just one country fails to ratify then the theory goes, the process comes to a halt. A recent article in the Economist analysed the possibilities and to an extent, but only to an extent, I concur. If just one or two countries say no then they may be asked to withdraw from the Union. (There is apparently a lively debate in the French press on whether the UK should be requested to leave). Such countries might then be allowed to negotiate a looser association with a closer Union. If more than just a few countries fail to do so, then the possibility exists of two blocs, a close political union and a looser economic one. The outer bloc might contain the UK, Poland and much of Scandinavia. A third alternative is that countries may pick and choose between a range of options, e.g. the UK opting into closer military union and Austria out of such. Even if all 25 countries ratify the treaty, then there is still danger to the evolution of a closer political union posed by Turkey’s entry which challenges the cultural and historical  roots of EUROPE.

The possibility then is that the UK will fall outside the inner group of the EU (indeed is already there). Where I part company with the Economist, is that this not a matter of great consequence. If it happens then over a prolonged period of time we would expect the divisions to widen. It is reasonably likely that a stronger United states of Europe will evolve and with this it is possible that Frankfurt will gradually overtake the City of London as the Continent’s major financial centre. It will obviously threaten structural adjustment funds coming from the EU, inward investment and so on. There may be other opportunities for the UK outside the EU and the region will need to be aware of them.


Extracts from the Constitution:

The Union is founded on the values of respect for human dignity, liberty, democracy, the rule of law and respect for human rights, including the rights of persons belonging to minorities. These values are common to the member states in a society in which pluralism, non-discrimination, tolerance, justice, solidarity and equality between men and women prevail.

The Union's competence in matters of common foreign and security policy shall cover all areas of foreign policy and all questions relating to the Union's security, including the progressive framing of a common defence policy, which might lead to a common defence.

Member states shall actively and unreservedly support the Union's common foreign and security policy in a spirit of loyalty and mutual solidarity and shall comply with the acts adopted by the Union in this area. They shall refrain from action contrary to the Union's interests or likely to impair its effectiveness...

The Council of Ministers:

... Except where the Constitution provides otherwise, decisions of the Council shall be taken by qualified majority...

Qualified majority:

A qualified majority shall be defined as at least 55% of the members of the council, comprising at least 15 of them and representing member states comprising 65% of the population of the union.

The European Commission:

The Commission shall consist of a number of members including its President and the Union Minister of Foreign Affairs corresponding to two-thirds of the number of member states, unless the European Council, acting unanimously, decides to alter this figure. They shall be selected among the nationals of the member states on the basis of a system of equal rotation between the member states.

The Foreign Minister:

The European Council, deciding by qualified majority, with the agreement of the president of the Commission, shall appoint the Union Minister of Foreign Affairs...

The Union Minister of Foreign Affairs shall conduct the Union's common foreign and security policy. He or she shall contribute by his or her proposals to the development of that policy, which he or she shall carry out as mandated by the Council. The same shall apply to the common security and defence policy...

The Union Minister of Foreign Affairs shall be one of the Vice-Presidents of the Commission. He or she shall ensure the consistency of the Union's external action...

In fulfilling his or her mandate, the Union Minister of Foreign Affairs shall be assisted by a European External Action Service. This service shall work in co-operation with the diplomatic services of the member states...

Specific provisions for implementing common foreign and security policy:

The European Union shall conduct a common foreign and security policy, based on the development of mutual political solidarity among member states, the identification of questions of general interest and the achievement of an ever-increasing degree of convergence of member states' actions.

The European Council shall identify the Union's strategic interests and determine the objectives of its common foreign and security policy...

Specific provisions for implementing the common security and defence policy:

The common security and defence policy shall be an integral part of the common foreign and security policy... [It] shall include the progressive framing of a common Union defence policy. This will lead to a common defence when the European Council, acting unanimously, so decides...

If a member state is the victim of armed aggression on its territory, the other member states shall have towards it an obligation of aid and assistance by all the means in their power, in accordance with Article 51 of the United Nations Charter. This shall not prejudice the specific character of the security and defence policy of certain Member States.

Commitments and co-operation in this area shall be consistent with commitments under Nato, which, for those states which are members of it, remains the foundation of their collective defence and the forum for its implementation...

Fiscal provisions:

A European law or framework law of the Council shall lay down measures for the harmonisation of legislation concerning turnover taxes, excise duties and other forms of indirect taxation provided that such harmonisation is necessary for the functioning of the internal market and to avoid distortion of competition...

Social policy:

... The Union shall take into account requirements linked to the promotion of a high level of employment, the guarantee of adequate social protection, the fight against social exclusion and a high level of education and protection of human health.

3. The Euro


The Euro was launched five years ago. It covers all but Sweden, Denmark and the UK of the pre-expansion EU. All 10 countries which joined in 2004 are expected to adopt the Euro although no date has been set. On the global stage the Euro has advanced to a position second only to the US dollar. For example in international loan markets the respective shares of euro and dollar loans to nonresidents are 37% and 46% respectively. In addition, in 2003 51 countries and territories outside the euro area relied on the euro as their reference or anchor currency or as part of a currency basket peg. It continues to gain strength against the dollar and is now trading at about $1.23= 1€ and against sterling at £0.68 = 1€.

    Membership of a single currency requires that the member states follow consistent fiscal policies. If  one, particularly large, country were to, e.g. run a large budget deficit then this would tend to push up interest rates throughout the whole of the Eurozone area. In order to impose fiscal discipline the Stability and growth pact was introduced which limited the size of fiscal deficits. Unfortunately it has not been conspicuous by its success and both France and Germany have been criticised for breaking the rules and apparently getting away with breaking them.

    Britain remains outside the Eurozone and at this point in time there seems little prospect of it joining, although the Treasury goes through a ritualistic annual dance of seeing if the conditions they have imposed are met. Basically this is a political decision and one dictated by the anti-European feeling apparent in our earlier tables. Does it matter? Being outside the Eurozone means that Britain is not subject to the same fiscal discipline as being a member of the SGP would impose. In addition, monetary policy and interest rates in particular can be set with respect to the needs of the UK economy and decided in London rather than in Frankfurt by the ECB. As against this the advantages of Eurozone membership are denied the UK, reduced currency risk and transactions costs, and loss of political influence and a widening of the gulf between the UK and much of the rest of Europe.  The economic disadvantages to firms, if positive will tend to see a drift of them towards Europe. This will be the case for all firms doing business in Europe, but perhaps particularly those engaged in the financial markets. The impact will not be sudden, but gradual and over time. To an extent some of the problems can be removed by UK entry into Eurozone, should that happen, but the loss of political influence may take longer to repair.

    In the meantime British businesses are still affected by the Euro.  UK businesses with eurozone clients have benefitted from cheaper transactions and accounting because of the single currency. 'The introduction of the euro gave companies an opportunity to make changes to their systems that cut costs and improved efficiency'. Where companies have been disadvantaged, it is where they have not taken steps to remain competitive, an example being only having prices on Internet in stirling..

    If the UK enters the Eurozone this will imply some changeover costs, obviously in terms of vender machines, but others two. Which companies are making progress with this? Work by green and Mole (2003) suggests that with respect to SMEs with trade links with the Euro currency area. A study was conducted soon after the initial launch of the Euro in 1999. A second study, using the same SMEs, sought to see how Euro preparations had changed by 2002 following the introduction of Euro notes and coins. At the univariate level, the results showed that the proportion of SMEs that were totally prepared increased from 31% to 44.3% whilst the proportion not prepared has also increased from 8.9% to 12.2%. The multivariate results show that directly trading manufacturers with a parent in the Euro area or who are seeking to acquire another company are more likely to have partially prepared for the Euro, which suggests a compliant ('just another foreign currency') rather than a strategic approach to the Euro. Trade links do not explain all the differences: incorporated manufacturing firms are significantly more likely to be partially prepared and less likely to be completely unprepared, indicating a possible impact of firm capabilities and sectoral differences. Firms looking to acquire others was the only significant business strategy variable.


Summary of An Article:

Life on the outside: economic conditions and prospects outside euroland David Barr, Francis Breedon and David Miles Economic Policy Volume 18 Issue 37 Page 573  - October 2003



The European economic and monetary union (EMU) is now over 4 years old. In this paper we assess whether monetary union has begun to have significant economic effects by comparing countries in EMU with the EU countries outside. We focus principally on trade creation between EMU member countries, using a methodology that controls for the fact that the decision to join the monetary union was not random but was more likely to be taken by countries whose prospects of trading with other EMU members were already high. We find that the trade effects of monetary union are significant. We estimate that had the UK been inside EMU the sum of its imports and exports could have been substantially greater. For comparative purposes, we also make preliminary estimates of the effect of monetary union on three other dimensions of economic performance: foreign direct investment, the development of financial markets and overall macroeconomic performance, though we recognize that our ability to control for other factors is more limited in respect of these other indicators. The evidence suggests that inward investment in the countries outside would have been greater had they joined EMU, but that the impact of this on GDP would be no more than 0.3% of GDP per annum for the UK and less than that for the other 'outs'. Financial market activity shows no clear sign of having been affected by EMU, and London's position as Europe's financial centre remains, as yet, largely unchallenged. On standard measures of aggregate performance - inflation, unemployment and output - no clear pattern of EMU effects has yet emerged

The trade effect of being out

The authors estimate the trade impact of being out of EMU. Their  estimated currency union effect is significantly smaller than that estimated by Rose, the results are still dramatic. For the UK in particular (which has experienced the highest exchange rate volatility of the three) the estimated trade impact is very large. They qualify their results with reservations. Firstly the analysis is limited to trade effect with EMU countries only. They also point out that the linkage between trade and GDP is not straightforward.

“ However, in a careful review of the evidence suggests that 'it seems reasonable to assume that each 1 percentage point increase in the trade to GDP ratio increases real GDP per head by at least 1/3 per cent in the long-run'. Using the figures… and converting the rise in trade with the euro-area to a share of GDP gives a long-run GDP gain of about 7% for the UK and Sweden, and 6% for Denmark [from joining the Euro].  Although this is only a one-off effect on the long-run level of GDP, it is not insignificant.


They find a marked weakening of FDI flows to the EU countries outside the Euro since 1999, although again they question the impact on the economy as a whole, because they question the usefulness of FDI.

The City of London

The introduction of the single currency raises the possibility that the centre of financial activity in Europe would shift from London to Frankfurt. With the ECB located in Frankfurt, and London being outside the union, the latter's status as Europe's financial centre was vulnerable. Aa they argue the crucial issue for London is whether it can remain the principal location for euro-denominated financial activity despite not being part of the euro area, particularly if the euro's importance as an international currency grows. They find some weakening in the City of London’s position, but in reality not much and they are reasonably sanguine on this. They tend to believe that this is due to London’s strength as a financial centre.


4. Investment


Foreign Direct Investment. The latest figures suggest a recovery in UK FDI according to Ernst and Young (bearing in mind the limitations of their data defintions). The number of FDIs in Europe during 2003 stood at 1,933 an increase of 2% on 2002. In the UK there were 453 (370 in 2002) and France 313 (254 in 2002). In Germany and Italy it has fallen off and also in the new accession countries. The UK and France’s increase was largely accounted for through expansion in existing projects, the UK from the USA and France from ‘intra-Europe’. This intra-European investment was the driving force for the overall increase of FDI in Europe, with the level of US investment continuing to fall. Germany is still suffering from structural problems. Much of this investment is expanding on something already in the country. The bulk of new FDI, i.e. without any previous presence in EU, continues to go to accession countries. The largest  growth by product type was in manufacturing, followed by contact centres and headquarters, largest single decline was in the number of sales and marketing operations. Business services, food, financial services, paper and pharmaceuticals showed strong growth. According to Ernst and Young in 2003 location strategies placed more emphasis on the quality of infrastructures and management of risk, thereby giving priority to transparency, clarity and stability in country characteristics.


Ernst and Young also report on venture capital investment, which saw a marked increase in 2004Q2 to 967.3m in Europe. This was boosted by significant health care investing (426.2m) as opposed to €420.9m in IT), particularly for biopharmaceutical and medical-devices companies.  Overall 32% of the deals were directed at seed- and first round financings, the highest for two years. The UK was responsible for most of the venture capital activity with 69 deals and 317.6 million invested


Summary of An Article:

The currency union effect on trade: early evidence from EMU


Economic Policy Volume 18 Issue 37 Page 315  - October 2003

Alejandro Micco, Ernesto Stein and Guillermo Ordoñez



The euro's trade impact is clearly important for the nations that have already joined euroland. But the size and nature of the trade effects are even more important for the EU members who have not joined the euro: the UK, Denmark, Sweden and the ten new nations scheduled to join next year. What are they missing? Will they face trade diversion if they do not join? For example, the debate on whether or not to join the euro is raging in the UK where it has been polarized to an extraordinary degree. This debate is in desperate need of economic analysis, in order to help clarify the potential impact of the euro on a number of dimensions, one of which is trade. This paper, we hope, will contribute to the debate, by providing estimates of the currency union effect on trade, for the specific case of the countries in the European Union. For this purpose, we use a panel data set that includes the most recent information on bilateral trade for 22 developed countries from 1992 to 2002. During this period 12 European nations formally entered into a currency union. This unique event allows us to study the effect of currency union on trade among a relatively homogeneous group of industrial countries. Controlling for a host of other factors, we find that the effect of EMU on bilateral trade between member countries ranges between 4 and 10%, when compared to trade between all other pairs of countries, and between 8 and 16%, when compared to trade among non-EMU countries. In addition, we find no evidence of trade diversion. If anything, our results suggest that the monetary union increases trade not just with EMU countries, but also with the rest of the world.

Their analysis shows that in the run-up to the creation of the single currency, intra-euroland trade flows increased more than bilateral flows between non-euroland nations. Second, the numbers also suggest that trade between euro and non-euro nations also increased, albeit not as much as intra-euroland flows.

On average, the euroland countries increased their share in the trade of other euroland members, but the overall increase was small (around 0.8%) and concentrated in a few countries. However, even this modest performance - which may be modest in part due to the better growth performance of the US and other non-European nations - shines in comparison to that of the rest of the EU countries. As a group, these countries lost more than 6% of their share in the euro zone's trade, with the loss reaching double figures in the cases of Ireland and Portugal. In fact, the non-euro EU countries lost share in each and every one of the countries in the euro zone. And in all these countries, without exception, they did worse than the euro members. Again, this sort of information is merely indicative, but it does serve to strengthen the idea that the euro may have altered trade flows.

They then expand this analysis using regression analysis: The euro boosts bilateral trade.The critical results concern the size of the euro's trade impact. Here the results suggest that the impact of EMU is important, even though smaller than previous estimates (Rose (2002, in his analysis of this literature, finds the currency unions approximately double a nation's trade). Altogether, the results show that two countries in euroland trade somewhere between 4 and 26% more than other country pairs, all else equal. Interestingly, the results excluding the pair dummies suggest the intriguing, but hard to believe, finding that the impact of EMU is comparable to that of EU membership itself.


6. Conclusions


The EU is at a crossroads. The UK’s relationship with the EU is at a crossroads. There is a strong possibility that the EU will not continue on the road to a Federal European state, even to the extent envisaged by the new Constitution. The UK with its traditional hostility to mainland Europe may well find itself on an outside track. A part-time member, seeking trade benefits but no more. To what extent the EU will allow this particularly in the long-term, we will have to wait and see. The empirical results reported here – and they are not unrepresentative – suggest that already there are costs to the UK in terms of lost trade and FDI. Little evidence is yet available on the impact on the City of London as a financial institution. I regard this latter evidence with caution. First one might expect any movements with respect to financial institutions to take longer. It takes time to build a presence, expertise, critical mass, more time than to decide to buy Italian shoes rather than Clarkes (who are something of a cult firm in much of Europe). But secondly, at the moment many people have been working on the assumption that the UK will eventually join the Euro. This illusion cannot be maintained indefinitely. If it ever becomes apparent that the UK will not be joining the Euro, then expect the landscape to begin changing more rapidly. Whilst if the UK were actually to become an arms length ‘partner’ of a new EU, then that is a new ball game. But there are other possibilities, some view one as the EU becoming moribund without any inner core – unlikely I would have thought. France, Germany, Italy, the Benelux and possibly more will continue their historic drive for closer union.



In google type “google scholar” as a search. You should come up with this page:

In the search box type “credit crisis” [putting “ “ limits the results to this phrase rather than just these two words perhaps not together

You find too much OK, “credit crisis” 2009

Alternatively try a person “Paul Krugman

Many of the articles that come up you can access there and then. If not go to University home page; right hand side click on Library click on e journals then for example type journal of ec you get about 31 journals. Choose “journal of economic perspectives” and follow instructions to access almost any journal paper in any journal.


go to University home page; right hand side click on Library click on data bases, then “W” then web of science. You can search for a topic, or an author. One idea might be the two words: [inflation survey] Alternatively go to citations and you can track down who has cited which author and what article. remember not all journals are equal. If you go to select data base at the top of ISI page you wqil lsee journal citation reports. Choose JCR social sciences, click [submit]economics, submit. Rank by impact factor.





adaptive expectations

average and marginal propensities to consume

balance of trade

Business cycle

capital output ratio

closed economy

Chapter 11 of the US Bankruptcy Code

circular flow of income.

crowding out

con adjustment

creative destruction

currency devaluation

disposable income

expected inflation.

fiscal policy

GDP - real and nominal



investment; inventory investment, residential and business

J curve

Kondratief cycle

liquidity trap

Marshall Lerner conditions

menu costs of inflation

M0, M2, M4 and M3H.

monetary policy

monetary policy committee



national income identity

natural rate of unemployment

nominal rate of interest

permanent income.

Philips curve

price elasticities of import/export demand

purchasing power parity

quantity theory of money

rational expectations

real exchange rate

real rate of interest

shoe leather costs of inflation

structural, frictional, cyclical, seasonal unemployment

transactions, speculative and precautionary demand for money

rational expectations

short run and the long run

sticky wages

The Taylor Rule

 Quantitative Easing


Credit default swaps (cds)

sub-prime market



Leave margins clear for the marker to put the marks clearly and hence make it easier to add the marks up. Get hold of past exam papers AT THE BEGINNING OF THE COURSE and this will help you prepare for the exam throughout the course. Model answers to past papers are not given. The objective is to test how well you can deal with questions from your own abilities not how well can you remember model answers. Read the rubric which tells you how many questions to answer from which sections. Allow adequate time to answer all questions properly. It is much easier to get the first 25% of the marks for any question that the last 25%. Hence allocate your time in accordance with the proportion of marks for that particular question or part of the question. Do not spend a page and a half on a question which accounts for 2.5% of the total marks. Take sufficient pens and pencils in with you to last the exam without running out - that is stupid. Make sure you know where you take the exam and beware often there are several different venues for the same exam. Make sure you know where you are. Draw diagrams in sufficient size to be seen and I would draw them well, but freehand, it is not an art contest (other examiners in other courses may want diagrams drawn more accurately however). Write in sentences and paragraphs. For essays, the opening paragraph should outline the question being answered and define any times. Each paragraph should then deal with a specific topic or part of a topic and once dealt with don’t go back until the conclusion. If you are asked to judge two approaches, specify each approach fairly and objectively. The conclusion should do more than just summarise the essay it should give added bite. Again, for example, if you have been asked to evaluate two different positions then do that, say which you think has most credibility - although in economics its seldom a case of position X being right and Y wrong, more both are a bit right and there is still room for some more explanation. The critical question is which has greater credibility IN YOUR VIEW. In multiple part questions do not leave any parts unanswered, GUESS if you have to. Just before an exam most people stand outside the room nervously talking amongst themselves, wasting the most valuable revision time of all. Then immediately after the exam they start looking up answers to questions they have answered, in effect revising for the exam they have just taken rather than focusing on the next one. Both a waste of time and frequently demoralising. In any case students are seldom good judges of how well/badly they have done in an exam. After an exam, I would go straight to the Library and immediately begin work on the next exam. Then after two hours of revision with my mind truly focused on what is to come, I would allow myself some relaxation.

Decide what essays you are going to focus on. If aid, write the essay and do a search throughout the document bring the material you need together including on innovation. Same with quantitative easing. The crisis is the backdrop to the crisis and on any essay on unemployment or economic policy you should have something to say on the crisis.

The Model:


Change middle band rate of income tax, i.e. move away from 22.

Change overall VAT rate

Government spending.

Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Virtual Economy Home page - Ground FloorDescription: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: .Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Case Studies - 1st FloorDescription: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: .Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Economic Policy - 2nd FloorDescription: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: .Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Library - 3rd FloorDescription: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: .Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: The Model - 4th FloorDescription: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: .


Top of Form


The Model

You are about to feel what it is like to be the Chancellor of the Exchequer, to run the nation's economy - or rather the Virtual Economy - as you think fit. Details available in the information point to the right.

To make changes, use the drop-down menus - just select the value that is closest to what you want, then click a 'Run Model' button. You can always reset the model and start again. There is also a simpler version, with just a few key variables available.

Please note that because of limitations in the model we use, the Benefit variables and the top rate of National Insurance have no effect on macroeconomic variables (prices, growth etc.), though they do affect households.

There is a help file available. (download print optimised version) (6k).

Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description:

Description: Description: Description: Description: Description: Description: Description: Description: Description: Description: Description:



 Income Tax

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Tax Bands

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Rate Threshold
in £ per year




Note that all income tax figures are in pounds (£) per annum.


Income Tax Allowances

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Personal Allowance

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 National Insurance

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Contacted-in rate

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 Indirect Taxes

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Beer (extra per pint)

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Petrol (extra per litre of 4-star)

Wine (extra per bottle)

Tobacco (extra per packet of 20)

VAT (Value Added Tax)

VAT on Specific Goods

Books (%)

Childrens Clothes (%)

Food (%)

Fuel (%)

Car Tax (Vehicle Excise Duty (%)

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Bottom of Form


[i] These figures are found by taking the exponential of the regression coefficient. For Wales this is 0.631, implying Welsh firms are only as 63% as productive as London ones. That is given the same workforce a firm in Wales will tend to produce 37% less than one in London. Labour productivity will depend upon the number of workers, but for firms with a workforce of a given size and holding all other characteristics constant, this figure  also represents the difference in labour productivity.