Explaining Paradoxes of UK Economy

Readers Question: There just seems to be many paradoxical actions taking place in markets and economies. To sum up my questions if we have; an increase in monetary supply, (as we do), Interest rates low and falling, certain commodities rising in price, certain commodities falling in price, a steady production of goods and a relatively steady velocity of money, and high unemployment.

What does it all mean?

For the past few years, we have been experiencing an unusual combination of circumstances where many ‘ordinary’ rules of economics are not occurring. The economy is currently experiencing a liquidity trap. A liquidity trap involves:

Low interest rates failing to increase demand. Usually lower interest rates boost spending because it is cheaper to borrow; but in this current economic situation, even interest rates of 0.5% have failed to see rapid increase in aggregate demand. Low interest rates have failed to increase spending and investment because

• Confidence is very low. People don’t want to invest when a double dip recession is forecast. People are reluctant to spend when they fear unemployment
• House prices and other assets have fallen. Therefore, this creates a negative wealth effect and discourages spending.
• Banks are reluctant to lend because of their liquidity shortages. Therefore, although it is in theory cheap to borrow, it is difficult to get a loan in the first place (e.g. mortgage criteria have become much stricter)
• Banks have a funding gap. This funding gap explains why extra money supply from Quantitative easing hasn’t led to higher bank lending – they have been trying to improve their balance sheet.
• Although Central Bank base rates have fallen to 0.5%, many commercial banks haven’t passed these interest rate cuts onto consumers
• See also: expansionary monetary policy

Has Money Supply Actually Increased in UK?

Quantitative Easing has led to an increase in the Monetary Base (Narrow money). The Bank of England have created money to buy assets from commercial banks. This has seen an increase in bank reserves and the deposits of commercial banks at the Bank of England.

• Mo (Narrow money) Money Supply has increased at a Typical Rate

• M4 Growth has been Weak

Source: Bank of England

Also the public sector has played an important role in increasing M4 Money Supply growth. (FT link) Quantitative easing has boosted M4 growth by 10%

Basically, what this means is that without the effects of quantitative easing, M4 money supply growth would have been negative. There would have been even lower economic growth and lower underlying core inflation.

Has Quantitative Easing Been Inflationary?

No. Because the increase in bank reserves have not really been lent out to the wider economy. The weak growth of M4 shows that despite the increase in Monetary Base, quantitative easing has not translated into stronger Money Supply growth and underlying inflation.

The weakness of underlying inflationary pressure can be illustrated by average wage growth. In the UK average wage growth has been very weak since 2008. In fact, we have seen a fall in real wages.

Why Have We Had inflation in UK?

Despite weak money supply growth (M4). Despite, high unemployment and low economic growth, we have experienced some inflation. This inflation is due to supply side factors. The inflation is not due to the usual causes of inflation (excess demand in the economy).

Inflation in the UK was high in 2008 and 2011 because

1. Rising price of oil – causes cost push inflation
2. Higher tax rates – causing one-off increase in tax
3. Impact of devaluation – causing rise in import prices

Now, that these temporary factors have expired, inflation will  fall and start to reflect the underlying core inflation.

This core inflation is low because of:

• Weak bank lending
• falling asset prices
• Weak wage growth
• Negative output gap
• High unemployment
• Weak Broad money supply growth.

See also: EU Core inflation

Related

• UK Economy 2012