Macroeconomic Objectives

The Importance of Macroeconomic Objectives

1. Full employment, or low unemployment

Although this objective was not considered so important in the 80s, when unemployment rose to over 3 million, it is still considered important by most economists, and the current Labour government have certainly made the goal of full employment more prominent.

It is important to keep unemployment levels as low as possible. High unemployment is expensive for the government and, therefore, for the taxpayer. For every unemployed person, there are two costs to the government. First, the unemployed worker will be entitled to benefit, and if he/she is young, or older but remains unemployed for a long period of time, he/she will be offered training under the 'New Deal'. Secondly, there is the less obvious cost of the loss of income tax revenues the worker would have paid in work. These workers would have been paying VAT as well through their purchases. Put together, some economists have estimated that the cost to taxpayers of each unemployed person is up to £9,000 a year.

Full employment, or low unemployment

There are other costs of unemployment. There is the cost to the whole economy in terms of wasted, unused resources. The existence of any idle resources means that the economy will be at a point within its production possibility frontier (PPF).

Unemployed workers (young men, in particular) may create other external costs in the economy, like crime for example. The governments of the 80s always dismissed the coincidence of rising crime figures and rising unemployment. Was it really a coincidence, given that many of the new unemployed were young school leavers with no experience in work?

Finally, there is the personal human cost to each worker. In the short term the unemployed worker has to put up with the loss of earnings, although this may be balanced by redundancy payments. But in the long run, the long term unemployed will find it harder and harder to find a job, as they find that the skills they have become less relevant and they have had no new training.

2. Price stability

Some would say that the main reason why the control of inflation is so important is that if inflation gets out of control, the economy stops growing. If inflation rises, the Monetary Policy Committee (MPC) is forced to raise interest rates. Consumers will stop borrowing to spend and firms will stop borrowing to invest. The housing market will slump, and along with it all the home improvement consumption that goes with it. Manufacturers exports will become less competitive. The economy may well drop into a recession.

Many economists worry about the redistributional effects of inflation. Periods of high inflation cause redistribution from savers to borrowers. Inflation erodes the real value of all money. Hence, if you are a net saver, the real value of your savings will fall, which is bad for the saver, but if you are a net debtor, the real value of what you owe will fall, which is good for the borrower.

The interest rate that is earned on one's saving will usually be higher than the inflation rate, but there have been times when the rate of interest does not keep up with the inflation rate, and so savers are paid a negative real interest rate. The best example of debtors gaining from inflation is the housing market.

Most of your parents will have 'made' money on their house. Of course, they do not 'realise' (i.e. get their hands on) this gain in wealth whilst they live in the property, but their mortgage remains relatively constant (especially if they are on a fixed rate mortgage) as their earnings rise over the years. Also, they can borrow against the increased value of the property to buy a car, go on holiday or extend the house.

Economists do not like this redistribution from savers to borrowers. It penalises thrift, which is a bad thing for the economy because, over the long term, the amount of investment in an economy is closely related to the amount of saving.

There are two minor costs of inflation. 'Shoe leather' costs refer to the time wasted (and worn shoe leather!) searching the market place for the lowest price. This is much harder when inflation is high. High inflation tends to coincide with variable inflation and, therefore, very unstable prices.

'Menu costs' refer to the costs of inflation to businesses in terms of continually having to change their menus, price tags, vending machines, etc. due to the continually changing price.

3. High (but sustainable) economic growth

Some would say this is the most important of all the objectives. Why? Since economic growth leads to improved living standards. Obviously this is good for the inhabitants of an economy.

Unfortunately, there always seems to be a trade-off between efficiency and equity in an economy. The most efficient economies in the world have grown the most and their inhabitants have experienced the best standards of living. But these economies tend to have the most unequal distributions of income. The competitive world of the free market creates winners and losers. The winners are exceptionally rich, but the losers can be worse off in absolute terms as well as relative terms unless the government's welfare state is generous.

To be fair, though, successful economies tend to grow so much that the standard of living of the poorest households in the economy still tends to rise. This was known as the 'trickle down' effect.

As the national cake gets bigger, the poor may well be getting a smaller slice (worsening distribution of income), but that slice will still constitute more cake as time goes by.

4. Balance of payments in equilibrium

For developed economies with mature and free capital markets, balance of payments disequilibria are not so important nowadays. If a developed country has, for example, a current account deficit, it can usually attract enough foreign investment on the capital account to balance their books. In other words, they can finance the deficit.

Some economists argue that it is a bad thing, but more in the sense that it is a sign of the uncompetitive-ness of the economy's industries. Economies with continual current account deficits are not 'paying their way' in the world.

The problem lies with developing countries that experience large current account deficits over a long period of time. They may simply not be able to finance this deficit. They need to pay for the imports in the currency of the country from whom the goods are bought. The US dollar is usually accepted worldwide. If they can't earn enough US dollars to pay for their imports, can't attract the foreign investment and can't convince other countries to lend them money, then they will be in trouble. Countries in this much trouble can knock on the door of the International Monetary Fund (IMF) looking for funds. These will only be lent under quite severe economic conditions, like keeping government spending down to a prohibitively low level.

Current account surpluses might not seem so bad (I'd prefer my bank account to be in surplus rather than deficit!), but they do mean that the economy is sacrificing consumption at home for exports abroad. Also, they can be bad for the simple reason that one country's surplus is another country's deficit. It is probably best not to ruin a country to which you export. Also, one doesn't want to sour trade relations, otherwise you might provoke a trade war (The USA and Japan have a lot of history here - see the previous Learn It). The USA and the EU are currently arguing over the labelling of products that contain genetically modified (GM) materials.

Which Macroeconomic Objective is the Most Important?

In the 1960s, the Balance of Payments was considered very important. A deficit was considered highly embarrassing in the days when many still believed, mistakenly, that Britain was a world power. The long-term sustainability of a deficit was a big problem in the days before global free movements of capital. Deficits would reduce the demand for the £ relative to other currencies, and so the value of the £ against other currencies would fall (see the topic called 'Exchange rates' for much more detail). This was unacceptable within the 'Bretton Woods fixed exchange rate system'. Nowadays, with a floating pound and huge global capital flows, many economists believe that balance of payments deficits or surpluses (on current account) simply do not matter. This was reflected in the fact that nobody seemed to bat an eyelid at the continual deficits of the 90s.

Full employment was considered very important after the Second World War. It was probably the number one objective of the socialist government of the late 40s and continued to be at the front of politicians' minds for the next three decades. Unemployment exploded under Thatcher in the 80s, but it was seen as an inevitable consequence of the steps taken to make industry more efficient. It was painful at the time but the lower levels of unemployment today are due, in part, to the structural changes made in the 80s.

The fact that deindustrialisation was occurring throughout the western world also made higher unemployment feel inevitable, and so this objective became much less important than it had been.

Growth and low inflation have always been important. Without growth, peoples' standard of living will not increase, and if inflation is too high then the value of money falls negating any increase in living standards. Nowadays these are definitely the two most important objectives of UK macroeconomic policy. The Chancellor is always going on about 'sustainable growth', meaning growth without inflation. Probably the biggest piece of economic news each month is the decision taken by the Monetary Policy Committee (MPC) over interest rates, their sole objective being the 2.5% target for the growth in RPIX (plus or minus 1%); a target that is still the responsibility of the Chancellor.

It is probably worth noting the following at this stage. Do not confuse objectives of macroeconomic policy with the instruments used to achieve these aims. Low inflation is an objective, the rate of interest is an instrument used to control inflation, not an objective in itself.

If one had to pick the most important objective today, it would have to be inflation. Although it should be growth, all government's efforts are devoted to the control of inflation. If this goal is missed, it is felt, then the goal of higher growth will not be attainable either.

On growth, there tends to be periods of strength (booms) followed by periods of weak or even negative growth (recessions). This is known as the economic cycle. All governments have a goal of eliminating this cycle. In other words, they want continual, reasonable growth that never ignites inflation, perhaps 2½% - 3% per annum. Recent governments have moved closer to this 'Goldilocks' scenario (not too hot, not too cold!). Notice that the growth rate has been over 2% without getting out of hand for six years. Following the 'bust/boom/bust' of the 'early 80s/late 80s/early 90s', this is quite an achievement.

Inflation has also been remarkably subdued by historical standards. Following the horribly inflationary 70s (peaked at 25%) and the near 10% figure ten years ago, RPIX has been growing at 3% per annum or less for six years.

The goal of full employment has effectively been consigned to the history books. Unemployment reached one million in the 80s for the first time since the 30s, and then proceeded to reach 3 million (or 4 million, depending on the definition) within three years. Having said that, 'full employment' does not mean that everyone has a job. Even in the 'full employment' era of the 50s there were still 300,000 unemployed. Today's figure is falling towards one million which some consider to be fairly close to full employment given the large amount of structural unemployment. This fall has been possible due to supply-side reforms of the Conservative governments of the 80s and the increased flexibility of the UK labour market, both of which have reduced the number of structurally unemployed people.

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It is a sad fact of economic life that UK consumers prefer imported goods to those made in Britain. The extent of the current account deficit mainly depends, therefore, on how well we export our services. Unfortunately, services are not quite as exportable as goods (how do you export a haircut, for example), so the UK is always fighting a losing battle. Hopefully the changes in technology, and our abilities to exploit them, will allow us to increase our exports of services by enough in the future to allow for the deficit in goods. Some economists believe that there is no problem, because in a world of perfectly mobile capital, the UK no longer relies entirely on their own pool of foreign reserves to pay for its imports. Nowadays, if you want something from abroad but you do not have the foreign currency, then just buy it on the foreign exchange markets!

Conflicts Between Macroeconomic Objectives

Unfortunately, it is virtually impossible for a government to score in all these goals at once. We shall begin with the three major conflicts and then look at two more that are linked to microeconomics.

If an economy grows too quickly, especially if it is due to excessive consumer spending as it tends to be in the UK, then demand will outstrip supply and prices will rise. Equally, the steps taken to keep inflation low, like relatively high interest rates, can often restrict growth via reduced consumer spending and investment. It is difficult to achieve both aims.

The 'trend' rate of growth is seen as the rate of growth an economy can grow without igniting inflation. Most economists believe that this is around 2½% to 3% at the moment. For the last six years the UK has managed to walk this tight rope without slipping into either higher inflation or recession. Perhaps the economic cycle has been eliminated, but most economists find this difficult to believe.

When an economy is growing quickly, consumer spending tends to be high. As we have already noted, British consumers tend to buy goods from abroad in preference to home produced goods. Hence, import growth picks up relative to exports, assuming an average growth rate in the countries that buy British goods, leading to a worsening trade deficit.

In the old days, when the balance of payments was seen as possibly the most important macroeconomic objective, the government had three options if they wanted to eliminate the deficit.

First, the exchange rate could be devalued within the fixed exchange rate system. A fall in the exchange rate would make exports relatively cheaper and imports relatively more expensive, and so help cure the trade deficit. Unfortunately, the increased import prices also caused inflation to rise.

Secondly, import controls could be used. These were physical controls on the number of imports allowed into the country, or taxes (tariffs) on imports, causing prices to rise. Both types of control reduced the amount of imports bought in the UK. Of course, the 'import controls' option is difficult to use these days with the World Trade Organisation.

Finally, the government could deflate the economy by increasing taxes or reducing government spending. The subsequent reduction in consumer spending will reduce the number of imports bought, but reduced consumption leads to a lower standard of living and a lower rate of economic growth.

This is the classic conflict in economic theory. In fact, an economist called Phillips constructed a curve (the Phillips curve) using empirical data to show that this conflict existed (although this did not mean that the relationship would hold forever).

These two variables have, in theory, an inverse relationship. If a government tries to reduce unemployment through reflationary measures, such as lower interest rates or increased public spending, then the resulting reduction in unemployment will push wages higher (as employers try to attract workers from a diminishing pool of the unemployed). This will lead to higher prices.

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On the other hand, when the government tries to control high inflation with higher interest rates and reduced spending, the resulting reduced consumer spending and lower investment will result in job losses. Norman Lamont, Conservative Chancellor of the early 90s, famously said '...unemployment is the price worth paying for lower inflation.'

Of course, not everyone would consider the environment a 'minor' objective, but unfortunately governments have not quite woken up to the problem yet. Although there have been summits at which controls on various types of pollution were agreed, the US amongst others seem to find it difficult to keep their promises!

Quite simply, the faster the rate of growth, the higher the level of production, and so the level of pollution from factories, cars, etc. rises. Also, vital rain forests tend to disappear, not just because we consume the wood; new factories, towns and housing are built on the resulting land.

Equality was an objective of socialist governments and so is now obsolete in the world of 'new' Labour! Although it is true to say that forcing equality throughout a country can lead to inefficiencies (where are the incentives?), those on the left wing feel that it is an admirable and important aim. Ronald Reagan (US President from 1981-89) used to talk about the 'trickle down' effect. As an economy grows the poor may well get a smaller slice of the cake, but the cake gets so large that the poor man still gets more cake. Of course this does overlook the fact that the rich man is getting a larger slice of a bigger cake!

The developed world has grown hugely since the Second World War, but even with the creation of welfare states it is the wealth creators that have benefited hugely whilst those at the bottom of the pile have seen their standard of living just plod along. The communist Soviet Union kept the more equality conscious socialist model going right into the 80s, but its inefficiencies meant that the rate of growth was much slower. Now even they have embraced capitalism, although the transition has not exactly been smooth! For lots more detail on transition economies, see the topic called 'Free market v. command economies'.

The Main Macroeconomic Objectives

Macroeconomics is concerned with issues, objectives and policies that affect the whole economy. All economic analysis that refers to aggregates is macro. The UK unemployment rate, the UK inflation rate, the rate of economic growth in the UK; these are all UK aggregates and therefore macro issues.

The four major objectives are:

  1. Full employment
  2. Price stability
  3. A high, but sustainable, rate of economic growth
  4. Keeping the balance of payments in equilibrium.

In this Learn-It, we will look at the way in which these objectives are measured. In the next, we shall look at why these objectives are important, their relative importance and how successful recent governments have been in achieving these goals. Finally we will look at the difficulties that governments have in trying to achieve all the objectives at once.

1. Full employment, or low unemployment.

The claimant count is the older, more out-of-date, measure of unemployment used in the UK. Those counted must be out of work, physically able to work and looking for it, and actually claiming benefit.

For a more realistic count, and for international comparisons, the ILO (International Labour Organisation) measure is used. This includes the young unemployed who are not always eligible to claim, married women who can't claim if their husband is earning enough, and those who claim sickness and invalidity benefits. Many only slightly inconvenienced unemployed workers are paid these benefits rather than swell the claimant count of unemployment.

Note the issue of active and inactive members of the population of working age. Only those who are active are included in the working population (or labour force), which is defined as all those who are employed or registered unemployed. But some of the inactive are in this category by choice, for instance, students and those who retire early.

At the moment in the UK, the level of employment is the highest ever (nearly 28 million workers). But one should note the significant difference in the numbers employed in manufacturing compared with the services (approximately 4 million against nearly 18 million).

2. Price stability

Inflation is usually defined as a sustained rise in the general level of prices. Technically, it is measured as the annual rate of change of the Retail Price Index (RPI), often referred to as the headline rate of inflation. For prices to be stable, therefore, the inflation rate should be zero. Generally, governments are happy if they can keep the inflation rate down to a low percentage. For an explanation of how the RPI is formulated, see the topic called 'Unemployment and inflation'. The UK government prefers to target the underlying rate of inflation, or the annual percentage change in the RPIX. This is the same as the RPI except housing costs are removed in the shape of mortgage interest payments. It makes sense for the government to use this measure because the weapon they use to control inflation, interest rates, directly affects the RPI itself.

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Other less popular measures include the RPIY, which takes RPIX a stage further by also taking out the effects of indirect taxation (e.g. VAT), and the consumer price index, which is often used when making international comparisons.

The inflation rates based on these measures for the whole of 1999 were: RPI, 1.5%; RPIX, 2.2% and RPIY, 1.6%. Another important statistic is that of average earnings growth. Most economists believe that the growth in wages directly affects the price level. The 4.6% figure for 1999 is reasonably low historically (certainly compared with the early 90s), but there are fears that it will have picked up during 2000. At the time of writing it was too early to get figures for the whole of 2000. This is something that you should look up yourself.

3. High (but sustainable) economic growth

Economic growth tends to be measured interms of the rate of change of real GDP (Gross Domestic Product). When the word real accompanies any statistic, it means that the effects of inflation have been removed. GDP is a measure of the annual output (or income, or expenditure) of an economy. Sometimes GNP (Gross National Product) is used, which is very similar to GDP. The only difference is that income earned from assets held abroad is added and the income earned by foreigners who have assets in the UK is taken away (officially called net property income from abroad). Growth figures are published quarterly, both in terms of the change quarter on quarter and as annual percentage changes.

UK real GDP growth was 1.8% in 1999, which is lower than the mid-90s, but much better than the recession of the early 90s. Remember that many economists were predicting 1999 to be a year of recession, so the final figure is really quite reasonable. Note also that there is a big difference between the growth rates of the manufacturing sector (-0.4%) and the service sector (2.8%). The service sector has been healthy for years, whereas the manufacturing sector, some would argue, has barely recovered from the recession of the early 90s.

4. Balance of payments in equilibrium

This is a very big topic in itself. Look at the topic called 'The balance of payments' for much more detail. Briefly, this records all flows of money into, and out of, the UK over a given time period (usually a year). It is split into two: the Current Account and the Capital and Financial Accounts (formerly the capital account, although examiners do still accept this name).

Probably the most important is the current account because this records how well the UK is doing in terms of its exports of goods and services relative to its imports. If the UK is to 'pay its way' in the world over the long term, then it needs to keep earning enough foreign currency from its exports to pay for its imports. If this is not the case, the current account will be in deficit.

Japan has the largest current account surplus in the world. Although a surplus sounds better then a deficit, both can be bad. Japan's surplus forces other countries in the world to have deficits. In fact, while Japan's surplus is the biggest in the world, the USA's deficit is the biggest in the world. This is not a coincidence! The UK tends to be in deficit, although the current account was in surplus a couple of years ago, mainly due to our strength in the service sector.

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Balance of payments

This is a record of all the flows of money into, and out of, the UK over a given time period (usually a year). It is split into two: the Current Account (exports and imports of goods and services) and the Capital and Financial Accounts (flows of money for investment plus government reserves of foreign currencies)

'Bretton Woods' fixed exchange rate system

In 1948, the Bretton Woods conference was one of the most important of the century. Not only did they set up the IMF and the General Agreement on Tariffs and Trade (GATT, which became the WTO), but they set up a fixed exchange rate system which gave the international monetary system much stability over the next twenty years.

Capital account

This is the commonly used name for the Capital and Financial account of the balance of payments.

Capital and Financial account

This is one half of the balance of payments. It measures all flows of money into and out of a country for the purpose of direct investment and portfolio investment. It also includes the government's foreign reserves and money borrowed and lent across boundaries in the banking sector. See the topic called 'The balance of payments' for details.

Claimant count

This is the official measure of unemployment in the UK. Those counted must be out of work, physically able to work and looking for it, and actually claiming benefit. It is not felt to be as accurate as the ILO measure, because it does not include many who are not working, but are not technically claiming unemployment benefit.

Current account

This is one half of the balance of payments. It measures all exports and imports of goods and services for a given country. It also includes investment income and transfers. See the topic called 'The balance of payments' for full details.

Current account deficit

If a country has a deficit on their current account then it means that it imports more goods and services (in terms of value) than it exports. Remember that the current account also includes transfers and investment income, which has to be included in these calculations. For more detail, see the topic called 'The balance of payments'.

Deindustrialisation

This is where economic activity moves away from manufacturing and into the service sector. It is the opposite of industrialisation. This process has been going on in the UK for a number of years now.

Economic cycle

Economies tend to have periods of strong growth (or booms) and then periods of slow or negative growth (slumps, or recessions). This process where the economy does well and then badly and then well again is known as the economic cycle. Governments would love to be able to eliminate this cycle and just grow at a steady, sustainable (i.e. without inflation) rate all the time. The current Labour government seems to have got close to doing this, but economists are dubious as to whether the cycle has gone for good.

Economic growth

Economic growth refers to the growth in real GDP, or the growth in the size of the economy after allowing for price rises.

External costs

This is the cost of an externality. If a factory, when making cars, pollutes a nearby river, then the external cost is the cost borne by the third party who has to clear up the mess.

Full employment

This does not technically mean that everyone in the country has a job. There will always be some people out of work, either voluntarily (early retirement, for example) or perhaps those who are structurally unemployed (Lost their job in an old industry and their skills are non-transferable). In the UK at the moment, the official claimant count of unemployment is about one million. This is considered to be fairly close to full employment.

Government spending

Governments have to spend money on certain essential services that would be under consumed if left to the market. Defence, education and health are examples. Governments use taxes to raise the money that they need to spend.

Gross Domestic Product (GDP)

GDP is a measure of the size of an economy. It can be measured using three methods. One can add up all the output (of goods and services) in an economy; one can add up all the expenditure (on the goods and services) in the economy or one can add up all the incomes earned (used to spend on the goods and services) in the economy. See the topic called 'Aggregate demand and aggregate supply' for more detail.

Gross National Product (GNP)

GNP is the same as GDP except that net property income from abroad is included. This is the income earned from assets held abroad minus the income that leaves the country earned by foreigners who have assets in the UK.

Headline rate of inflation

This is the inflation rate calculated from the Retail Price Index (RPI).

Import controls

These were popular in the days of fixed exchange rate systems, where an economy could not get away with changes in the exchange rate to cure current account deficits. Examples of import controls include tariffs (a tax on imports) and quotas (a physical limit on the number of imports). Most countries are now committed to free trade and so can only use import controls if the World Trade Organisation allows them to.

Inflation

Inflation is usually defined as a sustained rise in the general level of prices. Technically, it is measured as the annual rate of change of the Retail Price Index (RPI). It is often referred to as the headline rate of inflation.

International Labour Organisation measure of unemployment

This measure is felt to be more accurate than the claimant count because it is based on a survey and, on top of everyone in the official count, includes the young unemployed who are not always eligible to claim, married women who can't claim if their husband is earning enough, and those who claim sickness and invalidity benefits.

International Monetary Fund (IMF)

This institution was set up in 1948 to manage the international monetary system. All major countries contribute some money to the fund. The IMF then uses this money to stop struggling countries collapsing when they run out of foreign reserves. Although the major countries never need to call upon the IMF, it is important for them that other countries do not collapse. After all, they need markets for their goods!

Investment

When economists refer to investment, they mean firms' investment in new capital. They do not mean individuals' 'investments' in shares. This is actually a form of saving. One is saving one's money in shares.

Macroeconomics

Macroeconomics is concerned with issues, objectives and policies that affect the whole economy. All economic analysis that refers to aggregates is macro. The UK unemployment rate, the UK inflation rate, the rate of economic growth in the UK; these are all UK aggregates and therefore macro issues.

'Menu' costs

This is one of the minor costs of inflation. During periods of high inflation, prices are continually rising, so businesses have to continually change their menus, price tags, vending machines, etc. The cost of doing this is known as the 'Menu' cost of inflation.

Microeconomics

Microeconomics looks at issues associated with individual firms, consumers, workers or even industries. It is smaller scale compared with macroeconomic issues, hence the prefix 'micro'. It should be noted, though, that some micro issues, like the telecom industry in Europe, might be bigger than the macro issues of a small country like, say, Costa Rica.

Monetary Policy Committee (MPC)

Four days after the election of the Labour government in May 1997, the Chancellor, Gordon Brown, announced that decisions on whether interest rates should change would be transferred to the independent Monetary Policy Committee (MPC) of the Bank of England. The nine members of the committee meet once a month and announce their decision at midday on the first Thursday of each month.

Negative real interest rate

If the nominal (i.e. actual) interest rate is 6% (as it was for much of 2000), but the annual inflation rate is 8% (it was more like 2.5% during 2000), then the effective real interest rate is -2% (6 - 8). If you had £100 in the bank for that year, you would earn £6 interest, giving you £106. But something that cost £100 a year ago will now cost £108. So in real terms, the money has lost value sitting in your savings account!

New Deal

This has been one of the major policies of the Labour government. Put simply, it guarantees either training or a job to all young people. It has been so successful that the government is planning to extend the scheme to all those who are long-term unemployed, regardless of age.

Phillips curve

Phillips was an economist who spotted a relationship between the rate of change of money wages and unemployment. He used data from past years to show that this relationship was negative. Since this find (in 1958), economists have used it to state that the relationship between inflation (closely related to the rate of change of money wages) and unemployment is negative. Until the relationship broke down (although not entirely) in the 70s, governments used this relationship to gauge what the cost in terms of inflation would be for a given cut in unemployment, and vice versa. See the topic called 'Unemployment and inflation' for much more detail.

Price stability

Technically, this means that prices are stable. This means that the inflation rate would be zero. The term does tend to be used when the inflation rate is low. Prices are rising in this case, but very slowly, on average. Prices are still fairly stable when inflation is low.

Production Possibly Frontier (PPF)

This is a curve that tends to be convex to the origin and shows all the possible combinations of two mutually exclusive groups of goods (military and non-military goods, for example) where all the economy's resources are being used and in the most efficient way possible. It is important that both of those conditions are fulfilled for an economy to be in a situation on rather than within its PPF.

Real GDP

GDP (Gross Domestic Product) is a measure of the size of a domestic economy. To gauge how quickly the economy is growing, changes in real GDP are measured. Changes in real GDP take out increases in nominal GDP (the actual increase in GDP) that are due to price rises only.

Recession

Technically, a country is in recession if the economy's growth rate (percentage change in real GDP) is negative for two quarters in a row. If an economy is in recession then it is not doing very well! Negative economic growth tends to be the result of closing businesses and unemployment.

Redundancy payments

In many industries, if a worker is laid off, or made redundant, then he is compensated with a lump sum payment. The size of the payment depends of the length of time in the job.

Retail Price Index (RPI)

This is an index measuring the average change in the price level of a basket of goods and services. The average is weighted to reflect the relative importance of the various goods and services. The RPI is published every month and is then used to calculate the annual percentage change in the average price level (or inflation rate).

'Shoe leather' costs

This is one of the minor costs of inflation. During periods of high inflation, prices are continually rising, so it not so easy, as a consumer, to know exactly where to buy a good to get the lowest price. The search costs are higher. These are often called 'shoe leather' costs, because of the cost of replacing one's shoe leather having walked around loads of shops to find the best price!

Structural unemployment

This is unemployment caused by a change in the structure of an economy. For example, the decline in the manufacturing industry over the last thirty years has created many unemployed men coming up to retirement age who have only been trained in the skills required for the dead industry. They find it very hard to find another job. Often they will stay unemployed until they reach retirement age. They will be part of the huge group of 'long term' unemployed. Most of these 'long term' unemployed are structurally unemployed.

Supply-side reforms

These are reforms that improve the supply-side of the economy. Examples include privatisation and the taming of the trade unions. Notice that these supply-side reforms can improve the supply conditions in the product market and the labour market.

Tariffs

These are taxes on imports. They were once a very popular type of import control.

Thrift

Thrift is another word that economists use when they are referring to saving. If an individual is being thrifty, then they are being virtuous and careful in the sense that they are saving money.

Trade deficit

This is not the same as a current account deficit. A trade deficit occurs if an economy imports more goods than it exports, in value terms. It only refers to the 'trade in goods' section of the current account. For more details, see the topic called 'The balance of payments'.

'Trend' rate of economic growth

The 'trend' growth rate in this country is estimated by the government to be 2.5%. This means that the projected increase in the productive potential of the UK will allow the economy to grow by 2.5% a year in real terms without causing inflation to rise. The productive potential of an economy can rise for a number of reasons. First, there could be an increase in the amount of resources (increased population or finding new oil reserves, for example). Secondly, there could be improvements in technology. Thirdly, the labour force could become more productive and finally, firms and the government may invest in new capital.

'Trickle down' effect

Those who did very well out of the booming capitlist economies defended the system by claiming that there was a 'trickle down' effect. The idea is that although the rich are getting even richer, they create a lot of wealth for the economy as a whole, and some of this wealth 'trickles down' to the poorer members of society. The cake keeps getting bigger, the poor are getting a smaller proportion of the cake, but they still get more cake, because the cake is so big!

Uncompetitiveness of an economy's industries

If an economy's industries are uncompetitive, then they are struggling to sell their goods abroad in more competitive markets. This can happen if the value of a country's currency rises, making home produced exports more expensive abroad (this happened in 2000, when the £ was very strong). Exports can also be uncompetitive if they are of an inferior quality.

Underlying rate of inflation

This is the preferred measure of inflation of the government. It is calculated from the RPIX, which is the same as the RPI but with housing costs taken out in the form of mortgage interest payments. The government prefer this measure because it is unaffected by the instrument with which they try to control inflation (i.e. the rate of interest).

Unequal distribution of income

A country that has an unequal distribution of income has many rich individuals but also many poor individuals. The gap between the rich and the poor can be very large. Capitalist economies create a lot of wealth, but tend to have unequal distributions of income. The former Soviet Union was very inefficient, but did at least have a fairer distribution of income.

Value Added Tax (VAT)

This is the major indirect tax in the UK. It is imposed on goods and services, and is only paid by an individual if the good or service in question is purchased. Its current rate is 17.5%. Some goods are 'zero-rated', the tax is levied at 0% (i.e. there is no VAT on these goods). These goods tend to be essentials, or necessities. Many basic foodstuffs are zero-rated. The idea is that poorer people, who spend more of their incomes on necessities, will end up paying less VAT.

Welfare state

This is the phrase used to describe the government's system of benefits and services provided to help, in particular, those whose start in life was not good. It makes sure that every member of society will receive a minimum standard of living. It includes education and health services, as well as a selection of benefits, such as housing benefit, unemployment benefit and chid benefit.

Working population

Also called the labour force. This includes all members of the population of working age (16 - 65 year old men and 16 - 60 year old women) who are either in employment, or unemployed but willing and able to work, and actively seeking work.

World Trade Organisation (WTO)

The General Agreement on Tariffs and Trade (GATT) was formed at Bretton Woods (a small town in the USA) in 1948. Its aim was free trade throughout the world (free from import controls, that is). Tariffs averaged 50% just after the war. By the time that the GATT became the WTO in 1993, tariffs averaged 5% around the world. Whereas GATT was a series of long meetings between countries called 'rounds', the WTO is an on-going organisation to which countries can complain if they feel another country is obstructing the sale of their exports in an unfair way. See the topic called 'Why trade?' to see why free trade is a good thing.

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