Definition of Full Employment

Readers Question: explain how economists define ‘full employment’?

The first definition of full employment would be the situation where everyone willing to work at the going wage rate is able to get a job.

This would imply that unemployment is zero because if you are not willing to work then you should not be counted as unemployed. To be classified as unemployed you would need to be actively seeking work. This does not mean everyone of working age is in employment. Some adults may leave the labour force, for example, women looking after children.

But, in practise, we never see 0% unemployment, and this can make full employment hard to define. Generally, unemployment rate of 3% or less would be considered to be full employment. But, this is a figure the UK hasn’t experienced for many decades.

Optimal Unemployment Level

Another definition of full employment would be the ‘optimal’ level of unemployment. In practise, an economy will never have zero unemployment because there is inevitably some frictional unemployment. This is the unemployment where people take time to find the best job for them. Frictional unemployment is not necessarily a bad thing. It is better people take time to find a job suitable for their skill level, rather than get the first job that comes along. Generally, you may expect frictional unemployment to cause an unemployment rate of 2-3%. Therefore, some economists may claim that unemployment of less than 3% indicates ‘full employment’ – or at least very close.

Full Employment and Full Capacity

Another way to think of full employment is when the economy is operating at an output level considered to be at full capacity. i.e. it is not possible to increase real output because all resources are full utilised. This would be a point on a production possibility frontier. It can also be shown by AD/AS diagram.

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Consumer led recovery and investment led recovery

Readers Question: What is the difference between Consumer led recovery and investment led recovery

In this instance recovery refers to the economy coming out of recession. It means the economy starts to have positive economic growth. Economic growth can be caused by various factors see causes of economic growth.

Consumer led growth means that consumer spending is the main cause of rising aggregate demand and economic growth.

Consumer spending accounts for 66% of AD. Rising consumer spending may lead to an increase in imports and possible current account deficit. In the long term there is more chance that consumer led recovery will cause inflation. However, if the economy is recovering from recession there is likely to be spare capacity in the economy.

Investment led recovery means that firms are investing in new capital. They will employ more workers and reduce unemployment. Investment led growth will increase Aggregate Demand and increase productive capacity. It means that Aggregate Supply will rise. This leads to long term improvements in the economy. Living standards may not rise immediately because consumer spending doesn’t rise that much. However, in the long term the economy may be stronger than if it had been consumer led.

Reasons for an Appreciating AUS Dollar

Financial reporters suggested that fluctuating interest rates were responsible for the AUD/GBP
fluctuation described above, and that the AUD/NZD change was due to lower inflation in Australia.
Explain how the change in exchange rates could have been caused by those events.

Interest rates.

Interest rates have a powerful influence on the exchange rate because of hot money flows.

Suppose you have £100,000 to save in a bank. If both Australia and UK have same interest rates (5%) it doesn’t matter where you save your money. However, if Australian interest rates increase (6%) and UK interest rates fall(4%). There is a clear incentive for investors to save in Australia and benefit from higher interest rates. Therefore, people need to buy Aus Dollars to save in Australian banks. British investors wills sell pounds to buy Aus Dollars This causes the value of Aus Dollar to rise against the British Pound.

  • Note Australian interest rates are likely to be higher if the Australian economy has a higher rate of economic growth


If one country has a lower inflation rate, then its goods will become increasingly competitive and this will lead to increased demand for the currency.


Another reason for the appreciating dollar is the increased demand for commodities that Australia is producing. In recent months the price of many commodities such as precious metals has increased, this has increased demand for Aus dollars to pay for Australian exports

See: Australian economy 2008

Predictions for Australian Dollar

Australian and New Zealand Dollar

Readers Question:

Part A ii)
On 1 July, AUD1 = NZD 1.10. On 1 August, AUD1 = NZD 1.15.

On 1 July, your aunt in New Zealand booked the accommodation your families will stay in when you have a family reunion in Melbourne in August. She expects this to cost NZD 5400 when she pays the bill on August 1. You agreed to cover the costs she might incur if any exchange rate fluctuations took place between these dates. Will you have to help out? How much will you have to pay?

Again the important thing to note is that the Australian Dollar has appreciated in value. In August the Australian dollar now gains more NZD. It has appreciated by 4.5%. Therefore the cost of buying Australian goods will be higher for people paying with NZD.

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Australian Dollar and British Pound

Readers Question:. (i) On 1 March, AUD1 = GBP 0.42. On 1 July, AUD1 = GBP 0.45.
Your company exports native flowers to British florists. You signed a contract on March 1 to sell 10
tonnes of flowers at AUD 385 per tonne, to be delivered on July 1. Explain how the exchange rate
movement between the two dates impacts on the Australian seller.

On 1July the Australian Dollar has appreciated against the British Pound. 1 Australian dollar now gets 0.45 GBP rather than 0.42. This means British companies will have to pay more in Pounds to get the same amount of Australian goods.

For example, in March, the price of buying a tonne of Australian flowers is 385* 0.42 = GBP 161

In July the price of buying the same tonne is 385 * 0.45 = £173

Therefore, the appreciation in the Australian Dollar makes the Australian flowers more expensive for British importers. In this situation Australian exporters may do two things

  1. Keep the same price in Australian Dollars, this may lead to a fall in demand by British importers.
  2. Try and keep the price for British importers. This means they would have to reduce their profit margins and accept a lower amount of Australian Dollars. If they kept the price £161 then with the new exchange rate the Australian exporters would only receive 161 / 0.45 = 364 Aus Dollars.

The Rahn Curve – Economic Growth and Level of Spending

Readers Question: Does the Rahn Curve support the empirical evidence? If not, why not? Can you prove that there is a relationship between the level of Government Spending and GDP growth.

The Rahn Curve suggests that there is an optimal level of government spending which maximises the rate of economic growth.

Diagram of Rahn Curve


Proponents of the rahn curve tend to use it as a tool to argue that government spending hinders economic growth. For example the Centre for Freedom and prosperity [link] point to empirical studies which suggest that the optimal level of government spending is between 15 and 25% of GDP. That page also shows links to other reports and empirical studies which would be worth investigating for your paper. However, you should bear in mind:

  • Government spending in US is approx 37% of GDP, in UK approx 43% of GDP, in western Europe some countries have more than 50%
  • The Centre for Freedom and prosperity has a clear ideological stance that they dislike government spending. It is not surprising they highlight studies which show results favourable to their belief in reducing the role of government
  • There is a rather tenuous link between growth rates and levels of spending. There are many factors that influence rates of economic growth and I am dubious that people can ever isolate just one factor (levels of government spending) to prove either higher or lower growth rates.

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Forward Exchange Rate Contracts

A forward exchange rate contract is a way of insuring your contracts (such as buying a property) against fluctuations in the exchange rate.

For example, if you agree to buy a house for Euros 20,000 an appreciation in the Euro, could increase the Pound Sterling value by a considerable amount.

The way forward exchange rates work.

On a particular day, there will be a spot price for future contracts between the Euro and Pound. If you buy this contract then you are able to exchange money at a specified day for this particular price.

It means that you can have certainty that you will be able to buy foreign exchange at a certain price. It enables you to have insulation against rapid fluctuations.

This is an example of a bank offering forward exchange contracts

Predictions for the Euro 2009

Readers Question: Buying a new property in Montengro

  • 215,000 Euros’s
    paid 30% at exchange 1.47 to pound August 2007
    20% due in 2-3 months. 43 ,000 euros
    today exchange is bad news approx 1.23 to pound
  • further 30% due around Nov -Dec 2008
    20% on completion around April 2009

1.What are your predictions for the pound euro exchange rate at the time points above. June 08 – April 09?

I would be reluctant to stipulate a figure for the Euro / Pound exchange rate, especially with so much resting on your decision. People do talk of an exchange rate of 1 Euro to £1. This is because:

  • Weakness in UK housing market and UK economy. This could lead to lower interest rates in the UK in the next 12 months. If the UK housing market really collapses as some people fear, the £ will only get weaker.
  • Chance of Euro becoming worlds’ reserve currency instead of dollar. If central banks made the switch to the Euro, it would continue to gain in strength for a long time.

However, it is worth bearing in mind. Continue Reading →

The Real Rate of Inflation

In the UK there is a strong mistrust of the government’s inflation figures. People often feel that their cost of living is rising faster than official CPI statistics.

CPI inflation is calculated using a comprehensive price survey of 1000 of the most popular goods and services. However, there are a number of reasons why people feel inflation is increasing faster than government statistics.

1. CPI excludes housing costs. The official measure for inflation used to be the RPI. RPI inflation is currently higher than CPI; RPI inflation is closer to 4%.

The CPI also excludes the council tax increases that have been rising faster than inflation.
2. There is a variance within the average basket of goods. The average inflation rate is 4%, but some goods like food, energy and petrol prices are rising by up to 15%. If you spend a high % of your income on these goods your personal inflation rate will be higher than the average inflation rate. For example, the inflation rate for many pensioners is higher than the average because they spend a high % of their income on energy and food. However, if you spend a large % of your income on electronic goods your personal inflation rate may be less than the national average.

Graph shows that electricity prices are much more volatile than average inflation. If a high % of your income is spent on fuel, you will have a higher personal inflation rate. See also: fuel poverty

  • Some people who may be adversely affected are those who are currently re-mortgaging. The cost of a fixed rate is significantly higher than 2 years ago. Their effective cost of living may be increasing very significantly at the moment. This is ignored by the CPI.

3. Psychology. You might argue that people tend to remember bad news more than good news. For example, the increasing price of petrol is well documented by the media and there are constant reminders as you drive around. However, it is easier to forget that the price of computers and mobile phones are becoming better value. Therefore, because we give more weight to ‘bad news’ rather than ‘good news’ our perceptions on inflation may be wrong.



Bailout for Mortgage Companies

Yesterday, the bank of England  offered a scheme to bailout the banking sector by offering to exchange ‘unpopular’ mortgage debt for government backed securities.

The money markets have struggled since last summer and the American subprime crisis. This has led to a shortage of funds for mortgages and increased cost of mortgages.

I wrote an in depth analysis here: – Bank of England Bailout for Mortgage companies.

It is not certain how successful it is going to be. Abbey announced this morning that they will increase their mortgage rates anyway.

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