Author Archive | Tejvan Pettinger

Effect of minimum wage on AD/AS

Readers Question I realise that at the maximum wage, (minimum wage) for labour – Qty supplied would exceed quantity demanded. Therefore, from the labour market diagram there is an obvious fall in Qty of labour, given that there would be an unwillingness to supply labour at the lower wage rate.

Diagram showing minimum wage above the equilibrium

n-minimum-wage

I think you mean minimum wage. It is a minimum wage that causes excess supply of labour and lower demand.

If labour markets are perfectly competitive and if there is a national minimum wage (NMW) above the equilibrium wage, you would expect a fall in demand for labour (Q1 to Q2) and therefore, there would be excess supply of labour (Q3-Q1) (Known as real wage unemployment)

My question is how would I show this impact on an Aggregate demand and Aggregate supply (AD AS) diagram?

If we assume labour markets are competitive and if we assume that a minimum wage does cause lower employment, the most likely scenario is a negative impact on aggregate demand. People who become unemployed would spend less, leading to lower aggregate demand. To some extent, this would be counter-balanced by some workers having higher wages, leading to more consumer spending. But, I think the unemployment effect would be greater than the higher wages effect.

From the firms perspective, they would have higher costs, which could be passed onto consumers, higher wage costs could see SRAS shift to the left, leading to higher prices and slightly lower real GDP.

That is most likely analysis of AD/AS

 

Real World Analysis

In the real world, I think a minimum wage would have only a marginal impact on AD/AS analysis.

Firstly, a minimum wage may not cause any unemployment. Labour markets may not be competitive, but monopsonistic.

Demand for labour may be wage inelastic. Firms just pay higher wages and there is little fall in demand.

Only a small percentage of workers are affected by a minimum wage.

If anything, I would expect a minimum wage to increase AD. I’m doubtful UK Minimum wage causes any significant levels of unemployment. But, with a higher NMW some workers would receive higher real income and spending would rise. (Low income workers tend to have higher marginal propensity to consume / low propensity to save)

It is possible a rise in minimum wags could cause inflation due to two factors

  1. - higher spending by workers (demand pull inflation)
  2. - higher costs for firms, leading to wage push inflation.

But, overall, the effect on inflation would be fairly limited because a minimum wage would only alter AD by a small amount.

Essentially a minimum wage has little macro-economic effects (unless, it was a really big increase in the minimum wage)

Related

Maximum wage

If you did mean a maximum wage, the analysis for maximum wage is entirely different, I will do a post on maximum wages next.

But, demand for labour may fall. Firms may have lower costs, but some workers would have lower wages.

Maximum wages are rarely talked about. I can only think of professional footballers having a maximum wage until 1960s.

 

0

Scotland post referendum

An independent Scotland would have made an interesting economics case study. How would Sterlingisation  or a Currency Union have affected the Scottish economy? Now we may never find out. There were undoubted risks involved, though I’m not sure how much the issue affected the outcome. The Eurozone is also an interesting economics case study, but it has been a disaster for those who are at the receiving end of austerity and mass unemployment. I’m glad we don’t have a situation where five years down the road Scotland is marooned by English monetary policy and a lack of a Central Bank. Perhaps the SNP lacked the confidence to go all out for independence which means their own currency and Central Bank.

Last week, I made a rare foray away from economics in writing about why I emotionally I hoped Scotland would stay part of the UK

However, I watched an interview of Alex Salmond a few days later and was surprised at how much I agreed with him. I agreed with his views about nuclear weapons, the Iraq War, vague notions of social justice and what constitutes a good nation. I was reassured by his homilies  about Scottish independence would mean England losing a surly neighbour and gaining a good friend. He is a talented politician – probably very skilled in knowing what his audience would like to hear. I suppose he’s not always been so forthcoming in promoting English / Scottish oneness. But, as the campaign went on I was impressed by the optimism of  the Scottish independence movement – even if I was glad Scotland voted no.

There are times when you feel a bit small minded for always thinking of economic risks, pension funds and optimal currency areas.  There are more important things than economics and financial stability, but whether Scottish independence is, I’m still not entirely sure.

Referendum Question

If the question had been:

Do you want to remain part of the UK?

The campaign and outcome may have been quite different. It would have been easier for the Better Together campaign. The Better Together Campaign were criticised (with a degree of fairness) for being ‘negative’ – but when you campaign for a “No” vote – it does lend itself to a certain negative slant.

If the Scottish Independence movement were campaigning for a no, they would have found it much harder. In some senses it was quite a generous question that the UK government agreed to put on the ballot paper.

Democracy

Looking through human history, it is remarkable to have an independence debate which is wholly democratic and – despite rising tempers towards the end, remarkably good natured and peaceful. It is a powerful example of democracy in action; it is something that both Scotland and the UK can be proud of.

There are many regions looking in envy on both Scotland and the UK

Post referendum Squabbles

There will be inevitable post-referendum squabbles, especially revolving around the last minute vow of the three main parties. But, however difficult and problematic – they are nothing compared to the bitter divisions which would have been created by independence. The SNP had already put on the table walking away from their share of the national debt. Osborne had already ruled out Currency Union (without making much effort to explain why it wouldn’t be good for Scotland). A split in the union would have been a messy divorce. This is probably best outcome of the result – at least it’s clear and we can move on.

I haven’t read so many political articles since I was 18 and actively involved in politics. It certainly has touched something deep in Scotland and Great Britain. A very interesting experience.

Related

0

Does inflation cause unemployment?

Readers Question: Does inflation causes unemployment?

There are a few different scenarios where inflation can cause unemployment. However, there is not a direct link. Often we will notice a trade off between inflation and unemployment – e.g. in a period of strong economic growth and falling unemployment, we see a rise in inflation – see Phillips Curve.

Also it is important to bear in mind, (especially in the current climate) If the economy has deflation or very low inflation and the monetary authorities target a modest rate of inflation, then this may help boost growth and reduce unemployment.

Inflation can cause unemployment when:

  1. The uncertainty of inflation leads to lower investment and lower economic growth in the long term.
  2. Inflationary growth is unsustainable leading to a boom and bust economic cycle.
  3. Inflation leads to decline in competitiveness and lower export demand, causing unemployment in the export sector (especially in a fixed exchange rate).

 

Inflation creates uncertainty and lower investment

One argument is that a period of high and volatile inflation discourages firms from investing. Because inflation is high, firms are less certain investment will be profitable. It is argued that countries with higher inflation rates tend to have lower investment and therefore lower economic growth. Therefore, if there are poor levels of investment this could lead to higher unemployment in the long term.

It is argued that countries with low inflation rates, such as Germany have enabled a long period of economic stability which helps to attain a long term low unemployment rate. Low inflation in a country like Germany also helps them to become more competitive within the Eurozone, which also helps create employment and reduce unemployment.

See also: costs of inflation

Continue Reading →

Unemployment Stats and Graphs

A selection of graphs and statistics on UK measures of unemployment. Also, looking at factors that explain UK unemployment and why unemployment has fallen in recent years.

UK unemployment-rate

Current UK Unemployment rate

  • Unemployment rate of  6.2%, (July 2014) –  the lowest since late 2008. (page updated Sept 18th, 2014)
  • 2.02 million – (ONS)  (a fall of 468,000 since 12 months ago – biggest fall since 1988)
  • (Scottish unemployment of 6%)
  • Average Eurozone unemployment – 11.5%

Recent Unemployment Trends

UK-unemployment

Raw data:  Labour market data  | ILO unemployment % rate at ONS

UK Employment Rate

  • 73.0% of people aged from 16 to 64 were in work (May to July 2014) up from 71.6% for a year earlier.
  • There were 30.61 million people in work.

Participation Rate

  • 22.1% per cent inactivity rate for those aged from 16 to 64. 8.95 million economically inactive people aged from 16 to 64. In activity means that people are either not working or not seeking employment (e.g. students, parents bringing up children, early retirement, long term sickness) See also: Participation rates

Continue Reading →

Currency substitution – Dollarisation / Sterlingisation

Currency substitution occurs when a country uses another currency without any official backing and without a Central Bank – instead of using its own currency.

For example, Panama uses the US Dollar as its currency. Even though it has no formal currency union with the UK. Jersey uses Sterling unofficially too.

The advantage is that a country like Panama gets to use a currency which has a stable value and international respect. The disadvantage is that it has little control over monetary policy and doesn’t have a Central Bank to act as lender of last resort to print money during periods of liquidity. Also, you lose the ability to devalue the exchange rate (which some may argue has advantages too)

Sterlingisation for Scotland

If Scotland vote for independence, Sterlingisation is seen as the best outcome for an independent Scotland. (Possibly as a precursor to a second stage where Scotland creates its own Central Bank and print its own ‘Scottish Pound’)

Sterlingisation would mean Scotland continues to use the Pound, but without a Central Bank as lender of last resort. It also means monetary policy would be set by the Bank of England.

Does it matter if Scotland doesn’t have a lender of last resort?

Given the problems of the Eurozone in recent years, there is an unfortunate precedent of countries being severely damaged by a lack of a Central Bank willing to act as a lender of last resort. However, there are two possible factors which could help Scotland.

  1. Firstly, some argue that having no Central Bank encourages banks to act more responsibly and avoid taking on excess risks. The Adam Smith Institute have produced a paper which is optimistic about the potential of ‘Adaptive Sterlingisation’ arguing that the period of free banking in Scotland in the eighteenth century was largely successful – with banks secured by shareholders. – How sterlingization and free banking could help Scotland flourish at Adam Smith – Institute.
  2. Would the Bank of England want to allow banks in the British Isles to fail? If Scotland gained independence, the Bank of England would have no compulsion to act as lender of last resort, but the UK banking systems is closely integrated; a collapse in confidence north of the border would have implications south of the border too. Would the Bank of England want to allow a failure of our near neighbour – when the financial and economic fortunes of the two countries are so closely tied together?

Continue Reading →

1

Difficulty in switching from fossil fuels and oil

Question and answers on the difficulty of switching from non-renewable energy sources, such as fossil fuels. (from – finding alternatives to fossil fuels)

solar-power-houses

photo Dean

Readers Question: Why is it that on a global scale, alternative fuels are somewhat being ignored?

 

Firstly, fossil fuels are still cheaper. However, the gap is narrowing. For example, see how solar panels are coming down in costs.

There can be a reluctance to switch from one mode of production to another. Even if an alternative became cheaper, it requires significant investment to switch from one mode of power to another. For example, the UK kept steam trains running into the mid 1960s. Diesel was more efficient and cheaper many years previously, but it required a lot of investment in infrastructure to buy new diesel trains. Often it’s easier to keep going with old technology out of habit and merely because it is what has been used in the past. In some parts of the world, steam power is still used.

But, on the other hand, if we look back in history, we can see that a dominant technology can quite quickly lose its position. America quite quickly switched from steam trains to the petrol powered car. Once a tipping point is reached the momentum can swing to the new technology.

Also, a factor is that oil and petrol companies are very profitable and it is in their interests to keep oil based industries strong. If they can delay a switch to alternative fuels they might try. How much ability they have to delay an energy switch is open to question. But, there are powerful lobbyists to support the US coal and oil industries.

Readers Question: If it is not being ignored, Why is research and development is somewhat slow?

Alternatives to fossil fuels are generally not profitable in the short term. Therefore, private enterprise has limited incentives to research alternatives. This is an example of market failure, because the market ignores:

  1. The long term importance of developing alternatives to fossil fuels, which will one day run out.
  2. The external benefits of developing alternatives to fossil fuels, e.g. improvement in environment and reduced pollution.

Continue Reading →

0

Scotland in the UK

Generally I try and remain politically uncommitted. But, in the past few weeks, I’ve been surprised at how much the issue of Scottish independence has affected me. Despite a mental desire to feel nationalistic identity as unimportant, I feel deep down it really means a lot – and I hope Scotland votes to remain part of the UK.

scotland

Edinburgh – Clatie K

Essentially, I like the fact the United Kingdom is a union of different nations who celebrate both their uniqueness and common shared heritage. I feel Great Britain is stronger through maintaining this unique union. To split up and go it alone would feel like a regressive, backward step, which would accentuate division rather than the potential for oneness between the constituent parts.

I admire Socrates’ immortal quote:

‘Neither an Athenian or a Greek, but a citizen of the world.’

To me this is something to aspire for – to move on from sectarian nationalism to appreciate the greater possibilities of working together. I get joy from seeing groups with seek to bring nations together – from the United Nations to the ideals of a European union of nations.

I get more joy in thinking of myself as British than English. I prefer thinking of myself as British because it means we can celebrate a family of nations and this feels more to me than just a narrower ‘Englishness’. I also know this is perhaps a bit of anachronism – it seems the modern trend in the world is to split up and ‘go it alone’ (And, after all, I have to admit to being a secret member of the Yorkshire Independence movement, Oxford branch).

It does seem a shame to split up the United Kingdom. To me, it is hard to perceive Scotland as an independent separate country with borders and the like with England. I would hope Scotland still sees value in the union, even if they are at the same time proud of their Scottish identity.

The union of Scotland and the rest of the UK has lasted over 300 years. It has been a formidable union from the Scottish Enlightenment to the defeat of Hitler in WWII. The British Empire was bad in nearly every way, but I am proud of the fact that we gave it up and more or less moved towards a progressive democratic society with a strong welfare state. It is a unique union with surprisingly little internal division. For all the faults of the Westminster elite – how many nations offer a better standard of living? There is always corruption and poor politicians – no matter how small your governing nation. But, if you look at the rest of the world, the UK is a relatively good place to live in.

Mutual need

Whether we like or not, we have an indivisible mutual need to get on with our neighbours. John Donne wrote no man is an island, and this is particularly true in the modern world. Scotland has such a long tradition of merging with England, there are so many mutual ties that these cannot be passed aside. We benefit from Scotland and Scotland benefits from the rest of the UK. Just a few years ago, the whole UK banking system was on the verge of collapse. Scottish banks needed a massive bailout from the whole UK government. A real crisis was averted, but it was an example of how there is strength through union.

Independence means an independence currency

There has been a recent debate about whether prices will rise in Scotland after independence – this is an irrelevance – they may rise 0.5% they may stay the same. The real issue is whether the Scottish economy will be damaged by severing ties with Britain. The Eurozone is standing as a painful example of what happens when currency unions go wrong. I am fairly confident UK and Scottish unemployment would be close to double the current rate of 6.5%, if we had joined a currency union with Europe. An independent country without control over its – currency, monetary policy and fiscal policy is a essentially a vassal of the more powerful country. Some people worry about prices rising 0.5%, I worry about economies stuck in recessions with no ability to get out of it. Portugal, Greece, and Spain are currently economically failed nations.

It seems the strongest argument for Scottish independence is that Scottish people want to be free from Westminster influence and – for better or worse – be responsible for their own destiny. If this is the case, an independent Scottish currency and Central Bank is essential. What is the point of independence if Scotland shares –

  • The British currency,
  • Has monetary policy set by the Bank of England,
  • Relies on the Bank of England as lender of last resort
  • Has fiscal rules dictated by Westminster and the City of London?

This is the worst of both worlds.

In some respects a new Scottish currency will be a regressive step, – not least transaction costs will be a pain for people travelling between the two countries. But, at least the costs are more certain. A currency union or Sterlingisation would be a disaster for Scotland – maybe not straight away, but at some time. Scotland is lucky to have the painful failure of the Euro experiment to learn from. It would be a mistake to wave away problems with a rose tinted optimism – that is exactly how the Eurozone disaster was created.

Currency unions don’t work without very close economic and political union. A bad currency union only creates political and economic disharmony.

My fear is that Scotland will get independence and five years later will be bitterly complaining that rUK monetary policy is inappropriate. It will be inevitably bitter and tortuous arguments with both sides exasperated at each other. Just look at how much periphery Eurozone nations resent being told by the EU to implement austerity and ‘internal devaluation’

If Scotland choose independence – go the whole way, but don’t fall in between the gap.

 

Conclusion

It is easy to dislike the tone of the political debate on both sides, I worry at the strength of feeling generated. I don’t mind admitting, I would be reluctant to visit Scotland in the current climate. But, this is an issue that shouldn’t be decided on political point scoring or the temporary appeal of political leaders. It is about the best outcome for the future of Scotland and the UK. I do hope that Scottish people will vote to remain part of the UK. And we promise not to elect a Mrs Thatcher again!

Maybe I am wrong, maybe it doesn’t matter if Scotland becomes independent – maybe it’s a good thing for Scotland; perhaps if I lived in Scotland I would see things differently. I don’t know. Nations are always changing – such is life. Perhaps the only important thing is how we get on with people, whatever their nationality. However, spending the next five years squabbling over the national debt and national assets will probably not be the best way to promote a sense of oneness between Scotland and the rest of Great Britain. The union is worth preserving.

 Related

0

EU inflation and deflation

The Eurozone inflation rate is 0.4% (ECB database)  (Sept 2014)

Eurozone HCIP inflation rate

eurozone inflation

HCIP (Harmonized consumer index prices) Source:| (ECB Inflation graphs, sometimes a few months outdated)

Food inflation

food inflation

Food inflation is currently negative. Food inflation tends to be one of the most volatile components. This negative food inflation is one factor reducing the headline rate.

Reasons for low inflation in the Eurozone

1. Temporary factors – lower food / energy prices. Core inflation is currently higher than the headline rate. Excluding energy, food, alcohol and tobacco, the inflation rate is 0.9%. However, even this core inflation is still well below the government’s target. Also, the headline rate of 0.4% is important for anchoring low inflation expectations. M. Draghi wrote about his concern of an inflation rate permanently below 1%-  which will anchor low inflation expectations (Der Spiegel interview)

2. Sluggish growth

Economic growth in the European Union has been very weak since the start of the great recession in 2007. Weak economic growth has put downward pressure on wages and prices.

Eu-growth

EU Real GDP Source: St Louis Fred

3. Unemployment

eurozone-unemployment

Eurozone unemployment has been above 10% since the middle of 2009. Persistently high unemployment rates create downward pressure on wages. With large pools of unemployed labour – there is downward pressure on wages, which is big factor in keeping overall inflation low.

4. Inflation expectations

Despite the on-going recession, the ECB and European officials have placed great stress on keeping inflation low. This is one factor that has helped anchor low inflation expectations throughout the Eurozone.

5. Monetary policy

The ECB has recently cut the interest rate, but in 2011 – concerned at a blip in inflation – they increased interest rates. The ECB have always erred on the side of caution with regard to inflation, but the effect has been a relatively tight monetary policy which has kept nominal GDP growth low. The other big difference between Europe and other areas such as the UK and US is that whilst the UK has US have embraced quantitative easing to increase the money supply, the ECB has not sought to create more money to deal with deflationary pressure. There is great resistance to this idea, especially in Germany. This is a reasons Eurozone inflation is lower than elsewhere.

6. Internal devaluation

In the Eurozone, many countries such as Portugal, Greece, Spain became uncompetitive in the Single currency. This led to large current account deficit. But, in the Eurozone, these countries can’t allow their currency to devalue. Instead they are pursuing internal devaluation – trying to restore competitiveness through lower wages, and cutting prices. However, this process inevitably causes lower inflation. Both Greece and Portugal have outright deflation as a consequence of this policy.

6. Austerity measures

The Eurozone crisis led to many countries implement austerity to cut budget deficits. In a recession, austerity measures have slowed down economic growth contributing to lower nflation.

7. Reluctance to reflate the economy

The Eurozone has a big trade imbalance – with Germany having a large current account surplus – indicating domestic demand is relatively low compared to export demand. Germany has room to boost domestic spending which would help the south of Europe restore competitiveness and increase exports. But, Germany is not keen on risking any inflation, so they have held back on domestic spending, keeping overall Eurozone GDP growth low.

Problems of low inflation rate

In one sense a low inflation is good news for consumers who are enjoying low food prices e.t.c. However, the problem is that this low inflation is entrenched and so we are likely to see this leading to wage freezes. Low inflation does not help consumers if wages are not growing (something UK is experiencing at the moment)

The bigger problems of low inflation is that it is increasing EU wide debt burdens. A moderate inflation rate would help reduce nominal debt to GDP ratios. But, with zero inflation, the effective debt burden becomes much harder to reduce.

Very low inflation is also likely to hold back spending and investment. Consumers may prefer to wait before spending – in the expectation prices will continue to fall. Firms may be reluctant to invest given the poor prospects for economic growth. This all contributes to deflationary pressures – which is exactly what the Eurozone should be trying to avoid.

More detail – Problems of deflation

Related

1

European unemployment crisis

Unemployment in many European countries has risen sharply due to the credit crunch and global recession. The worst hit countries include Spain (ES) and Greece (EL), who both have unemployment rates of over 24%. In the past few months, there has been a slight reduction in European unemployment, but, the prolonged period of mass unemployment is leaving significant social and economic problems for the whole Eurozone.
  • Unemployment rate in the Eurozone area: 11.5% (July 2014)
  • EU-28 Unemployment is slightly lower at 10.2% (July 2014)
  • Total unemployment in the EU-28 is 24.850 million (July 2014)
  • The Eurozone  (EA-18) jobless total is now 18.409 million. (link) The highest since records began.
  • Youth unemployment rates in the EU 27 is 21.8% (July 2014)
  • The lowest unemployment rates are in Austria (4.9 %) and Germany (4.9 %). The highest rates are in Greece (27.2 % in January 2014) and Spain (24.5 %).
  • By comparison, unemployment in Japan is 3.6%, and in US 6.8%. UK unemployment is 6.5%
  • Eurostat unemployment figures

EU unemployment

Source: ECB

 Causes of European unemployment crisis

After falling to 7.5% in 2008, the prolonged recession of 2008-13, has caused a sharp rise in unemployment.  The continent seems to be stuck in a deflationary spiral and is facing a prolonged double dip recession. Hardest hit debtor countries, such as Spain, Greece, Portugal and Italy are facing stringent budget cuts – which are depressing demand.

Will Eurozone break up?

But, in the Eurozone, there is little relief available to boost demand. Countries are unable to devalue. Monetary policy set by the ECB has been unflinching in targeting low inflation and offering little monetary easing – despite the prolonged recession. Also, depressed demand throughout the region is making it difficult to grow through increasing exports. Even northern Europe, which has had large current account surpluses are engaging in modest austerity. The result is that demand has remained depressed across Europe.

Despite its potentially damaging social and economic impact, throughout the 2008-13 European crisis, unemployment has had a relatively low profile –  European policy makers have always given the impression they are more concerned about appeasing bond markets and low inflation than tackling the more pressing problem of unemployment. There has  been a reluctance to tackle the fundamental deficiency of aggregate demand which is leading to lower growth and falling employment. Efforts to reduce unemployment have centred on talk of more flexible labour markets. This may be part of the solution for structural unemployment, but increasing labour market flexibility alone cannot deal with the cyclical unemployment.

Continue Reading →

8

Why is the Aggregate demand (AD) curve downward sloping?

Readers Question: I have read the following:“The AD curve is downward sloping. This is not because ‘people buy more things when they are cheaper’ (the most common misunderstanding about the AD curve )”. I don’t understand this as I thought that the quantity /price relationship for demand is inverse.

 

AD-curve

From a micro perspective it is true that a lower price will encourage you to buy more of that product. If the price of potatoes falls, you may buy more potatoes instead of pasta because potatoes are now relatively cheaper. This is an example of a fall in the price of a particular good.

However, from a macro perspective a general fall in prices (deflation) can have different effects. Firstly, a fall in the general price level means all prices are falling (there could be exceptions, but on average prices are falling).-  This is different to one good becoming relatively cheaper.

Firstly, why do we draw a downward sloping AD curve?

  1. At a lower price level, consumers are likely to have higher disposable income and therefore spend more. (Note this assumes that wages are constant and not falling with prices)
  2. If there is a lower price level in the UK, UK goods will become relatively more competitive, leading to higher exports. Exports is a component of AD so AD will be higher.
  3. At a lower price level, interest rates usually fall, and this causes higher aggregate demand

In practise do lower prices cause higher aggregate demand?

  • A period of deflation (falling prices) can often cause lower aggregate demand – especially if falling prices is accompanied with falling wages (or at least stagnant wages)
  • If prices are falling, consumers may delay purchases because they expect prices to be cheaper in the future
  • If prices (and wages) are falling, then consumers may see an increase in the real value of debt. Deflation increases the effective debt burden, leaving less for spending.
  • Falling prices may increase real interest rates - if nominal interest rates can’t fall any further.

Falling prices could be compatible with rising aggregate demand

If falling prices are due to technological improvements and enabling  higher real wages. In this case, we could get lower prices, but AD continues to increase.

If falling prices are caused by a recession and spare capacity, then we are much more likely to get lower AD. In a recession, wage growth will be weak and consumers nervous to spend. Falling prices will be not sufficient to encourage spending because confidence is low.

Related

0
Optimization WordPress Plugins & Solutions by W3 EDGE