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The Euro and deflation

By on April 4, 2014 in readers questions

A look at the effects of how an over-valuation of the exchange rate can cause deflation.

Readers Question: does an appreciation in the exchange rate cause deflation?

An appreciation does tend to reduce inflationary pressures. This is because after after an appreciation in the exchange rate:

  • Price of imports will fall, causing a fall in cost-push inflation.
  • Exports become less competitive, causing lower demand for exports. The rise in demand for imports and relatively lower exports will reduce domestic aggregate demand, helping to reduce demand-pull inflation.
  • The appreciation may increase incentive for manufacturers to cut costs to try and stay competitive.

If the country imports a lot of raw materials, such as oil, metals and good, then an appreciation will have a relatively significant effect on reducing inflationary pressures. It could cause deflation in exceptional circumstances.

But, will an appreciation cause deflation?

Deflation is quite rare in modern economies. Even heavily depressed economies often get just low inflation – inflation between 0 and 2%.

It depends on other factors in the economy. For example, if the appreciation is due to rising competitiveness and a strong economy, then there is likely to be normal economic activity and strong demand, despite the appreciation. Therefore, inflation can continue with an appreciation.

The impact on inflation will also depend on how much manufacturer’s pass the change in exchange rates onto consumers. After an appreciation, petrol prices may not fall as much as expected because petrol companies increase profit margins instead. Also, firms may engage in currency hedging so they smooth out currency fluctuations.

However, if the over-valuation in the exchange rate is accompanied by tight fiscal policy, tight monetary policy and a global economic downturn, then the deflationary impact of an over-valued exchange rate could well translate into actual deflation.

Long term over-valuation and deflation

eur-update_feb2014_deflation-blog-002

deflation in certain EU countries. Source: IMF

A slightly different scenario  to a temporary appreciation, is if a country is experiencing an exchange rate that is fundamentally overvalued for a long time.

This is relevant for several southern European economies who are in the Euro. Greece, Portugal, Italy and Ireland are all grappling with inflation of close to or less than 1%. Recently, prices have fallen in four countries, Greece, Cyprus, Portugal and Slovakia (Bloomberg)

In the Euro, these countries became uncompetitive, but there couldn’t be a devaluation because there is just one currency. To restore competitiveness, they are having to focus on reducing prices (a process known as internal devaluation). To some extent, this is causing deflation. Greece and Portugal lost so much competitiveness, that there is a need for a substantial fall in prices to restore competitiveness.

The over-valuation of the exchange rate is not the only cause of deflationary bias in the Eurozone. But, it is a significant one.

Therefore, being in a single currency (with no recourse to devaluation) can leave countries with significantly uncompetitive exports and an exchange rate which is unsuitable.  This can lead to deflationary pressures and even actual deflation, as Greece and Portugal are discovering at the moment.

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Deflationary Bias in the Eurozone

By on April 4, 2014 in economics

Readers Question: Is there an inbuilt deflationary bias in the Eurozone?

Deflationary bias means that there is a tendency for economic policy to promote lower growth and lower inflation. It means there are pressures which keep demand subdued leading to lower inflation, higher unemployment and lower growth.

To a large extent, I agree that there is a deflationary bias in the Eurozone. This is proved by the long period of low economic growth (2007-14) and an inflation rate that is remaining well below target. As of April 2014, inflation in the Eurozone has fallen to 0.5% – well below the target of 2%. Growth is anaemic and unemployment well into double figures (11%) – higher in many countries.

EU inflation

Source ECB - inflation

Furthermore, certain countries on the Euorzone periphery are experiencing actual deflation as the burden of adjustment is felt by certain countries more than others.

Inflation Target

The ECB have very strong attachment to keep inflation less than the target of 2%. For example, in 2011, temporary cost-push inflation led to an increase in the EU headline inflation rate. The ECB responded by increasing interest rates. The Bank of England responded by keeping interest rates at 0.5% (even though inflation was much higher in the UK than EU). The Bank of England argued it was important to give importance to wider economic issues of growth and unemployment. The ECB were much less willing to accept, even a temporary deviation from the inflation target over fears temporary inflation would increase inflation expectations. It showed the ECB are much more willing to risk lower growth than risk higher inflation. (see also: ECB v Bank of England)

Whilst the ECB have an inflation target, they have no explicit target for unemployment or economic growth. EU Unemployment has risen to 12%, but there has been little action to increase aggregate demand.

Reluctance to pursue unconventional monetary policy

Despite a prolonged period of low inflation, the ECB are still reluctant to actually implement unconventional monetary policy  (e.g. Quantitative easing). With inflation of 0.5% April 2014, the ECB had still not taken any pre-emptive action to target higher inflation.

The ECB is reluctant to engage in any quantitative easing because

  • They are reluctant to create any possibility of future inflation, printing money is an anathema to German Central Bankers.
  • The ECB has a reluctance to start buying bonds of different countries, deciding which to buy.

The result is that countries with many deflationary pressures (strong exchange rate, fiscal austerity) don’t have any monetary stimulus to offset the fall in demand. (e.g. UK can pursue quantitative easing when we experienced deep recession). Countries in Eurozone can’t.

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UK unemployment threshold of 7%

By on April 3, 2014 in monetary policy

Readers Question Why is the forward guidance threshold set at 7% unemployment and how does this affect the threshold for inflation?

The MPC have a remit to target inflation of CPI = 2% +/-1. But, the MPC also consider wider issues of economic growth and unemployment. UK Real GDP is still lower than the level reached in 2008. It is an unprecedented decline in output, and actual growth and fallen well behind trend growth.

real-gdp-00-13q3

Because of this the MPC have been concerned to return the UK to a normal path of economic growth, aiming at full employment, whilst avoiding any surge in inflation.

total-unemployment-2007-present

Because of the unexpected nature of the ongoing recession and economic weakness, last year they introduced forward guidance, stating that they wouldn’t raise interest rates above 0.5% until unemployment had fallen to 7%.

In 2014, unemployment has continued to fall faster than expected (unemployment is now 7.2%). But, at the same time CPI inflation has fallen below the government’s target. The MPC have updated their guidelines to say that there is scope for unemployment to fall below 7% without causing inflationary pressures. (Bank of England note on forward guidance)

Why 7% threshold?

To some extent, 7% is a little bit arbitrary. You could make a case for 6% or even 8%. But, essentially, it is a level of unemployment which the MPC believes shows that the UK is stuck with spare capacity (and below trend growth). With unemployment of 7%, the MPC believe that there is likely to be no demand pull inflationary pressures, and therefore they can afford to keep interest rates low without it causing any inflation.

With unemployment of 7%, the MPC predict that wage inflation will remain muted. 7% unemployment is sufficiently high to deter workers from bargaining for higher wages. Wage inflation is a key factor in determining headline inflation. The fact that wage inflation has remained very low is a key factor in encouraging the policy of forward guidance and keeping interest rates close to zero.

The MPC hope that forward guidance will giver greater confidence for firms to invest – knowing that interest rates are more likely to stay low.

Impact on inflation

If the economy recovers sufficiently and unemployment falls further, then we could see a re-emergence of inflationary pressure. As unemployment falls, wages may start to increase causing both cost-push and demand pull inflation. With higher inflation, interest rates of 0.5% will look unsuitable for a recovering economy.

The fear is that by promising to keep interest rates at 0.5% until 2015, the MPC may be too late in dealing with an increase in inflationary pressures caused by the economic recovery.

However, there are various factors suggesting that despite falling unemployment, there is still a strong case for keeping a loose monetary policy (keeping interest rates low)

  • Headline unemployment has fallen due to a rise in part time / temporary contracts.
  • The fall in unemployment has been helped by stagnant wage growth.
  • Some suggest that the headline rate of unemployment is somewhat misleading to the state of the economy and labour market. (UK unemployment mystery)
  • Support for the continued existence of spare capacity in the UK economy is strengthened by the fall in CPI inflation to 1.7% in Feb of 2012. Inflation has now fallen below target. Some economists are concerned that there is still a risk from disinflation (low inflation) Deflation is very unlikely in the UK.
  • There are likely to be deflationary pressures from ongoing weakness in the European economy and further fiscal tightening from the government. Given these deflationary pressures, the MPC are keen to do help maintain demand.

Should Central Banks have a target for unemployment?

On a slightly different note, there is a case for Central Banks to have a target for unemployment (though I admit it is hard to decide on a figure for full employment.)

But, we may contrast the role of the MPC with the ECB which has placed much less emphasis (if any) on European unemployment, but seems primarily concerned with inflation.

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UK Inflation Rate and Graphs

By on April 1, 2014 in A-Level, economics, stats

Current UK Inflation Rate

  • CPI  inflation rate: 1.7% (headline rate)
  • CPIH grew by 1.6% in the year to Feb 2014
  •  (page updated April 3rd, 2014)

monthly-inflation

CPI and CPIH

CPIH is a new experimental index from the ONS. It is based on CPI, plus it includes housing costs, such as mortgage interest payments. Owner occupiers cost (OOH) account for 12% of the CPIH weighting. Mortgage interest payments are the biggest part of OOH. Mortgage interest payments average 10% of household expenditure.

cpi-cpih-inflation

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How reliant is the UK economy on oil?

By on March 26, 2014 in economics

Readers Question: How reliant is the UK economy on oil?

There are two ways of considering this question – the consumption and production of oil.

  • Firstly, how much does the UK need to consume oil to maintain economic activity? Could we survive in a post-oil economy?
  • Secondly, how important is the UK oil industry and the production of oil?

Consumption of oil

UK_oil_production-consumptionThis shows that we are consuming a steady 1.5 to 1.7 million barrels of oil a day. Oil is an essential raw material for many key economic activities, such as:

  1. Transport – cars, lorries e.t.c. mostly rely on petrol / diesel. (In the US transport accounts for 66% of all oil used. I imagine it is a similar statistic in the UK.)
  2. Production of plastic
  3. Fertilizers
  4. Asphalt
  5. Polyurethanes
  6. Solvents
  7. Electrical generation

Reducing dependency on oil consumption

  1. There have been some attempts to reduce the dependency on oil. In transport, the government have encouraged the consumption of electric cars, with subsidies and encouraging electric car charging points.  But, between between 2010 and June 2013 only 5,034 electric cars have been registered. It is a small drop compared to the total number of cars sold.
  2. According to Calor, there are 160,000 LPG registered cars in the UK, and the number is on the rise.
  3. Energy efficiency. Cars have become more energy efficient with a high miles per gallon becoming a strong selling point. This has limited the growth in demand for petrol.
  4. Alternative forms of transport. Some see alternative forms of transport as a way to avoid reliance on oil based fuels. However, despite growth in cycling rates and increased use of trains, cars  / lorries still dominate the UK’s mode of transport.
4-modes-transport

The dominance of the car in the UK

However, the improvements in energy efficiency and attempts to introduce alternative fuel cars are only limiting the growth in demand for oil based fuel. Continue Reading →

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Top CO2 polluters and highest per capita

By on March 25, 2014 in economics, environment

Readers Question: What country’s don’t use the carbon tax and with country produces the most carbon dioxide.

The biggest absolute emissions come from China, and the United States. In terms of CO2 emissions per capita, China is ranked only ranked 55th, at 6.2 metric tonnes per capita. The US is 8th at 17.6 per capita. India is the third highest country in terms of absolute emissions, but 127th in terms of per capita output with 1.7 metric tonnes per capita.

pollution-smog

Why don’t countries use the carbon tax?

  • Taxes are generally politically unpopular. A tax on carbon emissions will affect the living costs of many people. This can make the government reluctant to impose the tax.
  • There is also the free rider problem. A small country may think – what is the point in introducing carbon tax when their CO2 emissions are dwarfed by other countries like China and the US? Especially, when these bigger countries don’t seem inclined to do too much about the issue.
  • There is also differing opinions about the potential cost of CO2 emissions to the environment. In the US, there is a strong lobby which argues global warming is not scientifically proven. Therefore, there is a resistance to impeded CO2 emissions.
  • Another factor is that there are significant vested interests in the oil industry / other industries which pollute. They fear CO2 tax will reduce their profitability so they are willing to fight against moves to introduce taxes.
  • Another argument used is that a Carbon tax will harm jobs.

Highest CO2 emissions by country

List of countries by 2010 emissions
Country Annual CO2 emissions
Thousands of tonnes  % of world
1. China 8,286,892 26.43%
2.  United States 5,433,057 17.33%
 3. EU (27) 3,688,880 13.33%
 4. India 2,008,823 6.41%
 5. Russia 1,740,776 5.55%
 6. Japan 1,170,715 3.73%
 7. Germany 745,384 2.38%
 8. Iran 571,612 1.82%
 9. South Korea 567,567 1.81%
 10. Canada 499,137 1.59%
 11. United Kingdom 493,505 1.57%
 12. Saudi Arabia 464,481 1.48%
 13. South Africa 460,124 1.47%
 14. Mexico 443,674 1.42%
 15. Indonesia 433,989 1.38%
 16. Brazil 419,754 1.34%
 17. Italy 406,307 1.30%
 18. Australia 373,081 1.19%
 19. France 361,273 1.15%
 20. Poland 317,254 1.01%

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Policies to reduce unemployment in Greece

By on March 24, 2014 in economics

Readers Question: What policy strategy is good to reduce unemployment in Greece?

The Greek economy is experiencing grave problems, with record levels of unemployment. Unemployment in Greece is running at 27.5% – (end of 2013) This unemployment rate is even higher amongst young people.

The unemployment is primarily caused by the prolonged recession which has led to a substantial fall in output and decline in normal economic activity.

The Greek economy has also suffered from a lack of competitiveness in the Eurozone. Higher labour costs and rising production costs caused Greek exports to be relatively uncompetitive. But, in the Euro, there was no devaluation to restore competitiveness. This lack of competitiveness is a contributory factor to unemployment, and led to a current account deficit of close to 15% at the start of the crisis.

What can Greece do?

From a theoretical point of view, a country experiencing severe demand deficient unemployment, should seek to pursue policies to increase aggregate demand.

However, the difficulty is that in the real world, these three policies are all curtailed by membership of the Euro.

Greece is actually pursuing a very tight fiscal policy – cutting government spending in an attempt to reduce the budget deficit. These spending cuts are making the recession worse and increasing unemployment. But, in the Euro, they feel they have no choice because the have no other way of funding their deficits. One policy option would require the EU to give even bigger bailouts or wipe out Greek debt to enable them to stop austerity. However, this would require a degree of political willingness we are unlikely to see.

Monetary policy is not set by Greece, but the ECB. The ECB is considering the whole of the Eurozone and so is not setting monetary policy for what Greece needs. If Greece had a Central Bank, they could print money and pursue quantitative easing to try and reduce deflationary pressures and boost demand. But, this option is not currently available to them.

Several economists suggest that the ECB should be doing more to help the depressed Southern economies. They argue the ECB and Germany need to do more to boost demand in Europe and help those economies experiencing deflationary pressures. Higher growth and higher inflation in Germany / north of EU would help restore competitiveness without relying on extensive deflation in the south. But, the ECB and Germany are reluctant to do anything which might ‘risk’ inflation.

Devaluation of the exchange rate is not possible within the Eurozone. Therefore, leaving the Euro is a consideration. Leaving the Euro would enable loose monetary policy, and substantial devaluation. This could help increase aggregate demand in medium / long term. Therefore, it could be a solution to the mass unemployment.

However, leaving the Euro would cause massive disruption and possibility of capital flight. Many Greeks would wish to move their Euros out of Greece to protect against imminent devaluation. This could destabilise the economy and lead to even lower economic growth, unless sufficient capital controls could be introduced to keep capital in Greece. However, the advantage of leaving the Euro is that it would put the economy back into the hands of the Greeks, and avoid a similar repeat of this crisis in the future.

Other solutions

Supply side policies. The EU has called for supply side reform to help improve competitiveness and reduce unemployment. This can involve labour market reforms to increase labour market flexibility and reduce wage costs, encouraging firms to employ more workers. This policy may help a little, but, even the best supply side reforms will only make quite a small dent in the overall unemployment picture. The fundamental problem is lack of demand, supply side reforms will take a long time to have an effect on unemployment of 27%.

See: Supply side policies for reducing unemployment

Radical policies

In some aspects the Greek economy is changing quite rapidly. In some areas, people are avoiding normal economic channels and resorting to an almost barter economy. New employment may spring up as people create completely different economic channels such as selling directly to shops rather than through intermediaries. This may help reduce unemployment, but I’m not sure what policy can help create these ‘unorthodox’ jobs.

 

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Devaluation of the Indian Rupee

By on March 20, 2014 in A-Level, currency

The Indian Rupee has fallen in value against a basket of currencies since independence in 1947. In recent years, the Indian Rupee has continued to depreciate in value.

Indian Rupee value against US Dollar

INR-USD_v2.svgIn 1990, you could buy $1 for 16 Indian Rupees. By 2013, the value of a Rupee had fallen, so that you would need 65 Indian Rupees to buy $1.

Another way of thinking about it:

  • In 1990 1 Indian Rupee = $0.06
  • In 2013 1 Indian Rupee = $0.016

This shows there has been a substantial fall in the value of the Indian Rupee against the US dollar.

When there is a devaluation in the Indian Rupee it means that Indian exports become cheaper, but imports are more expensive for Indians to buy.

In particular, a devaluation in the Rupee is bad news for Indians who need to import raw materials, such as oil and gold.

Causes of Devaluation in Rupee

Lack of competitiveness / inflation. The long term decline in the value of the Rupee reflects India’s relative decline in competitiveness. In particular, India  has a higher inflation rate than its international competitors. In November 2013, Indian inflation reached 11.24%. Therefore, there is relatively less demand for the rising price of Indian goods; this reduction in demand causes a fall in the value of the Rupee.

Current account deficit. A consequence of poor competitiveness and high demand for imports is a current account deficit. This means India is purchasing more imports of goods and services than it is exporting. A large current account deficit tends to put downward pressure on a currency. This is because more currency is leaving the country to buy imports than is coming in to buy exports.

In the first quarter of 2013 the Current Account Deficit was 18.1 billion. The deficit was over 6.7% in last quarters 2012, the deficit has fallen to 1.2% in Q3 2013. However, the Economist notes that 75% of the deficit reduction is artificially related to reducing imports of gold through government restrictions. (See: Indian economy 2014) Therefore, there is still an underlying trade deficit, India will need to work on through increasing exports and competitiveness.

A current account deficit can be financed by capital inflows (on the financial account). But,  recently, India has been struggling to attract sufficient long-term capital investment. Some major companies have recently pulled out of foreign direct capital investment. This puts more downward pressure on the Rupee.

Oil Prices

India is a net importer of oil. It has to buy oil in dollars. Therefore, rising oil prices worsen India’s current account and also weaken the Rupee. More Indian’s Rupee’s have to be spent on buying oil.

Impact of Devaluation in Indian Rupee

Inflationary pressures. India is trying to control inflation, which has been running into double digits. But, devaluation makes itself makes it harder to control inflation. The devaluation increases the price of imports, such as oil and fuels, leading to cost push inflation. Also, devaluation is considered an ‘easy’ way of restoring competitiveness, therefore devaluation may reduce the incentives for exporters to work on improving long-term competitiveness. Finally, devaluation can help boost domestic demand. Exports will rise and consumers will switch to domestic producers rather than imports. This can cause demand-pull inflation.

Economic growth

A devaluation can boost domestic demand and short-term economic growth. However, this is not necessarily helpful for the Indian economy. India’s economy needs to concentrate on boosting productivity and long term productive capacity, rather than relying on boosting domestic demand. The rapid devaluation has also caused a loss of confidence in international and domestic investors. With a history of quick depreciation, foreign investors will be more nervous of investing in India. The devaluation and inflationary impact will also discourage domestic investors, e.g. firms worried about future oil prices. This reduction in investment is damaging to long-term economic growth.

Devaluation spiral

The concern is that high Indian inflation causes devaluation, which in turn feeds into more cost-push inflation. Thus it becomes a difficult to escape out of this unwelcome negative spiral of inflation-devaluation-inflation.

Policies to stem devaluation in Rupee

  • Supply side policies to improve competitiveness
  • Reduce dependency on foreign oil, through domestic and renewable energy.
  • Monetary policy to tackle inflation and reduce domestic demand. But, will conflict with lower economic growth and lead to higher unemployment.
  • Financial controls, e.g. limiting the amount of gold imports to reduce the current account deficit.

 Related posts

Related posts on devaluation

Note on terminology: In strict terms, we should refer to the depreciation in the Indian Rupee. A devaluation means a fall in the value of a fixed exchange rate. But, in practical terminology, the distinction between depreciation and devaluation is often blurred.

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Key measures of economic performance

By on March 12, 2014 in A-Level, economics

Traditionally, the key measures of economic performance in macro-economics include:

  1. Economic growth – real GDP growth.
  2. Inflation – e.g. target CPI inflation of 2%
  3. Unemployment – target of full employment
  4. Current account – satisfactory current account, e.g. low deficit.

Of these indicators, economic growth is usually the most importance and given the greatest credence for economic performance. It is frequently used for international comparisons and is probably the most prominent statistic. Politicians can use GDP statistics as a trump card – as if a quarterly growth of 1.0% vindicates all economic policy.

However, real GDP has several limitations. Not least is the fact that it is not always a reliable guide to living standards. With stagnant wages, cost push inflation and a rising population, average median incomes have fallen in the recent decade. Between  2009-10 to 2011-12 median incomes fell  in the UK cumulatively by 5.9% from, taking average incomes back to levels seen a decade earlier. It means that despite the recovery in real GDP, some people feel that they are not benefiting from economic recovery.

Indicators for economic performance

The Fabian think tank believes that median income would give a better indicator to overall economic performance. They also state other indicators which would help give better impression of economy.

  • Rate of National debt reductions
  • Level of greenhouse emissions
  • Income inequality
  • Labour productivity
  • Intermediate skills
  • Affordable homes
  • Incidence of low pay
  • Employment rates

Pros and cons of GDP

For all its limitations, GDP is widely used across the world. It does gives a rough guide to the level of economic activity. The fall in GDP of 2008/09 was indicative of the recession. Prolonged growth of real GDP 1993-2007 was indicative of the relative prosperity and rise in living standards.

For all its faults GDP does give a useful guide to the economic cycle and is a indicator for monetary policy and fiscal policy.

GDP is also measurable – it is objective. For example, we could go to the other extreme and start a survey asking people whether they are happy with their economic situation? This may give an interesting insight into economic welfare. But, a raw statistics, such as GDP gives more confidence than a survey – which by its very nature is subjective.

The downside of GDP come when it is relied on too much. Rising GDP, could hide a fall in average incomes and a rise in poverty. GDP  doesn’t take into account income distribution. Growth in GDP could primarily benefit the top income strata.

For example, a problem the Fabian group identify is the rise in UK housing costs. In the past few decades, UK Housing has become less affordable. This is good new for home owners who see a rise in wealth and rents. It is bad news for people struggling to buy or pay rents. This is a classic example of how a rise in GDP can cause rising living standards for some, but falling living standards for others.

Don’t forget population. At the very least, we need to take into account population and real GDP per capita. The UK’s rising population is one reason for increasing GDP.

All statistics are limited

One problem is that all statistics have some limitation. Even employment rates can be partially misleading. For example is the employment temporary or permanent? Employment figures have been better than expected, but there has been a rapid rise in zero hour contracts causing an increase in labour market insecurity.

When I see national debt used as a measure of living standards I always start to worry. Countries which made enthusiastic attempts to cut their budget deficit, such as Greece and Portugal have seen a dramatic fall in living standards. It seems mistaken to use debt reduction as a measure of living standards when debt itself might be the necessary consequence of dealing with a demand side shock.

Overall

Overall, it is important for economists to look beyond the headline statistics. Real GDP will always be useful for showing the stage in the economic cycle. It is of some use in indicating living standards. But, it is far from the ultimate guide. There is always a need to look at similar statistics to give a better overall picture. In this case median income is definitely an important indicator to economic welfare. Similarly when looking at unemployment. It is insufficient to use just the raw unemployment data. We need to know the kinds and types of jobs created.

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Low economic growth and unemployment

By on March 5, 2014 in economics, unemployment

Readers Question: Why is it that when there is low economic growth, unemployment rises?

A low rate of economic growth can cause higher unemployment. Though it is not always the case. During 2010-13 the UK experienced a slow rate of economic growth, but unexpectedly unemployment fell.

If there is negative economic growth (recession) we would definitely expect unemployment to rise. This is because:

  • If there is less demand for goods, firms will produce less and so will need less workers.
  • In a recession, some firms will go bankrupt making many people redundant.
  • Firms will be reluctant to hire workers, when there is uncertainty and negative growth

Why unemployment can rise even with positive but a low rate of economic growth?

In many cases, we may see a rise in unemployment, even if there is positive, but low economic growth. One reason is that economic growth may be lower than improvements in productivity growth.

Suppose, an economy like the UK has a long run trend rate of 2.5%. This means productive capacity tends to rise by an average of 2.5% a year. This growth in productivity comes from improvements in technology and improvements in labour productivity. It means that firms can produce more goods and services from the same number of workers.

However, suppose that the rate of economic growth was 0.5%. This means demand in the economy is only growing by 0.5% a year. This means that supply would be increasing faster than demand. Therefore, firms may have to lay off workers because there is insufficient demand.

In this situation, we will see a negative output gap (spare capacity)

ad-small-inc-as-big-incr-yfIn the above example, we have positive economic growth, but AS (Productive capacity) is increasing faster than AD. Therefore, there is a bigger negative output gap (the difference between actual GDP and potential GDP (Yf). Therefore, in this case the rise in spare capacity leads to unemployment.

China and unemployment

A good example of this is the case of China. It is estimated that if economic growth in China slips under 7% a year, then unemployment will rise. This is because China is making rapid productivity gains. Old inefficient state owned business are being privatised and there are easy efficiency gains to make. Workers who were unproductive are being made redundant from these state owned industries. Therefore, China needs rapid economic growth to absorb this growing supply of labour.

Technology and structural unemployment

If there is rapid technological and structural change in the economy, this can cause unemployment despite economic growth. For example, rapid improvements in technology can create increased output, but certain workers may have insufficient skills to take the new high-tech jobs. Therefore, we can see a rise in structural / technological unemployment in the period of economic growth.

Low Growth and falling unemployment

There is no guarantee that low growth will cause higher unemployment. It is quite possible for unemployment to fall, despite a period of low growth.

If we look at the UK, unemployment fell from 2011 to 2013 – despite low growth, and also the expectation that unemployment would lag behind the recession.

total-unemployment-2007-present

Reasons for this fall in UK unemployment during this period include:

  • Poor productivity growth. Labour productivity has been low during this period. Therefore, firms still need to employ workers, despite limited growth in output.
  • Rise in part-time and temporary work. The unemployment figures have been helped by a rise in under-employment, people accepting lower hours than they would like.
  • Low wage growth. Low wage growth means labour is relatively more attractive than you might expect.
  • See: more at UK Unemployment mystery

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