Category Archives: Labour Market

UK Economy – Goldilocks and the output gap

Chris Giles of The FT wrote a very good article explaining the output gap using Goldilocks and the three bears. As you may know in the story Goldilocks found the first bowl of porridge too hot, the second bowl too cold but the third bowl just right. We can use this analogy with regard to the economy:

  • running too hot – a positive output gap – the economy is overheating and higher interest rates and less government spending is needed to slow the economy down.
  • running too cold – a negative output gap – the economy has a lot of spare capacity and needs to be stimulated by dropping interest rates and increasing government spending.
  • running just right – no gap – there is neither a requirement for an expansionary monetary and fiscal policy nor a contractionary monetary and fiscal policy.

Just as Messrs Friedman and Phelps had predicted, the level of inflation associated with a given level of unemployment rose through the 1970s, and policymakers had to abandon the Phillips curve. Today there is a broad consensus that monetary policy should focus on holding down inflation. But this does not mean, as is often claimed, that central banks are “inflation nutters”, cruelly indifferent towards unemployment.

If there is no long-term trade-off, low inflation does not permanently choke growth. Moreover, by keeping inflation low and stable, a central bank, in effect, stabilises output and jobs. In the graph below the straight line represents the growth in output that the economy can sustain over the long run; the wavy line represents actual output. When the economy is producing below potential (ie, unemployment is above the NAIRU), at point A, inflation will fall until the “output gap” is eliminated. When output is above potential, at point B, inflation will rise for as long as demand is above capacity. If inflation is falling (point A), then a central bank will cut interest rates, helping to boost growth in output and jobs; when inflation is rising (point B), it will raise interest rates, dampening down growth. Thus if monetary policy focuses on keeping inflation low and stable, it will automatically help to stabilise employment and growth.

Gapology

 

However policymakers rely on estimates of the output gap – which compares actual GDP with a country’s full capacity when all resources are fully employed. The concern that the Bank of England have is that official data shows that the UK economy is showing sluggish growth rates with a tight labour market.

Almost all employment indicators suggest the economy close to overheating – recruitment difficulties and industry facing capacity constraints. This is in contrast to economic growth which suggest that there is room for expansion. Add to this the uncertainty about Brexit, the reliability of the output gap even more dubious. Current techniques might correctly measure the output gap but what about the contribution of potential capital projects which are underway?

Some economists have suggested that output gaps are inherently political and chosen to rationalise existing policies, rather than to set the correct prescriptions. However for economists is there an alternative to taking the temperature of an economy.

Modern Monetary Theory vs Mainstream Monetary Theory

Although not in the A2 syllabus we have had some great discussions in my A2 class on Modern Monetary Theory – MMT. It has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.

MMT states that a government that can create its own money therefore:

1. Cannot default on debt denominated in its own currency;
2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
5. Does not need to compete with the private sector for scarce savings by issuing bonds.

Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

How does it differ from more mainstream monetary policy – see table below.

Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.

Below is a video from Stephanie Kelton, an MMTer who was the economic adviser on Vermont Independent Senator Bernie Sanders’s presidential campaign in 2016.

Sources:

The Economist – Free Exchange – March 16th 2019

Wikipedia – Modern Monetary Theory

Turkey’s economy – stuffed

Inflation at 25%, Central Bank interest rates at 24%, Lira down 30% in value since the start of the year. What hope is there for the Turkish economy?

Wages and salaries haven’t kept pace with inflation and the reduction in demand has led to higher unemployment. There is pressure on the central bank to keep interest rates to avoid the lira collapsing. However this makes it expensive for businesses to borrow money and thereby reducing investment and ultimately growth.

No pain no gain – there is no alternative for Turkey other than undertaking painful and unpopular economic reforms. Remember what Reagan said in the 1980’s “If not now, when? If not us, who?”  He was referring to the stagflation conditions in the US economy at the time and how spending your way out of a recession, which had been the previous administration’s policy, didn’t work.

In order to the economy back on track things will need to get worse but President Erdogan has the time on his hands as there is neither parliamentary nor presidential elections in the next five years. This longer period should allow him the time to make painful adjustments without the pressure of elections which usually mean more short-term policies for political gain. Beyond stabilising the lira, which helped to ease the dollar-debt burden weighing on the country’s banks and corporate sectors, the 24 per cent interest rate level the central bank imposed also brought about a long-overdue economic adjustment. A cut in interest rates discourage net inflows of investment from foreigners and the resulting depreciation would accelerate the concerns about financial stability and deteriorating business and consumer confidence. Below is a mind map as to why a rise in the exchange rate maybe useful in reducing inflation.

A2 Economics – Marginal Revenue Product Theory

Marginal Revenue Product of Labour

Marginal revenue productivity (MRPL) is a theory of wages where workers are paid the value of their marginal revenue product to the firm.

The MRP theory outlined below is based on the assumption of a perfectly competitive labour market and the theory rests on a number of key assumptions that realistically are unlikely to exist in the real world. Most labour markets are imperfect, one of the reasons for earnings differentials between occupations which we explore a little later on.

  • Workers are homogeneous in terms of their ability and productivity
  • Firms have no buying power when demanding workers (i.e. they have no monopsony power)
  • There are no trade unions (the possible impact on unions on wage determination is considered later)
  • The productivity of each worker can be clearly and objectively measured and the value of output can be calculated
  • The industry supply of labour is assumed to be perfectly elastic. Workers are occupationally and geographically mobile and can be hired at a constant wage rate

Marginal Revenue Product (MRPL) measures the change in total output revenue for a firm as a result of selling the extra output produced by additional workers employed. A straightforward way of calculating the marginal revenue product of labour is as follows:

MRPL = Marginal Physical Product x Price of Output per unit

Therefore the MRP curve represents the firm’s demand for labour curve and the profit maximising condition is where:

MRPL = MCL (Marginal Cost of Labour) where the revenue generating by employing an additional worker (MRPL) = the cost of employing an additional worker (MCL).

Mind Map below adapted from Susan Grant’s book CIE A Level Revision Guide

RNBZ can’t seriously be thinking about reducing the OCR

Today’s labour market data showed a drop in unemployment from 4.4% to 3.9% and an employment rate of 68.3% the highest since the HLFS survey was first reported in 1986. The
unemployment rate of 3.9% is the lowest since June 2008 and towards the lowest bound of the RBNZs estimated 4% to 5.5% range for the Non-Accelerating Inflation Rate of Unemployment (NAIRU). See graph below:

Tomorrow the RBNZ present their November Monetary Policy Statement (MPS) and these figures give them limited time to change any policy direction. Remember that the RBNZ is now tasked “supporting maximum sustainable employment within the economy” alongside its price stability mandate of 1-3% CPI with a target of 2%. However these figures seem to suggest that further easing is not required to meet employment objectives.

What is the Natural Rate of Unemployment?

The natural rate of unemployment is the difference between those who would like a job at the current wage rate – and those who are willing and able to take a job. In the above diagram, it is the level (Q2-Q1).

Source: economicshelp.org

The natural rate of unemployment will therefore include:
Frictional unemployment – those people in-between jobs
Structural unemployment – those people that don’t have the skills that fit the jobs that are available.

It is also referred to as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) – the job market neither pushes up inflation nor holds it back.

Source: BNZ – Economy Watch – 7th November 2018

Shorter hours, higher productivity and yoga

According to surveys today’s millennial job applicants don’t want to work all hours – it seems that younger workers place a work-life balance ahead of career progression. During the GFC an applicant who asked a prospective employer about leaving work early on a Friday to go to yoga wasn’t taken seriously. However with the global economy growing at its fastest rate since 2011, qualified jobseekers are scarce so workers can start to make demands.

IG Metall – Germany’s biggest trade union – struck a deal that allows members to work 28-hour weeks for up to 2 years, typically when they have small children. Although Germany is unique, other national economies might follow suit if they have a limited supply of workers. It is important to note that in boom times the substitution effect comes into play as more people want to substitute money for leisure time – this is shown by the backward bending supply curve of labour. In most A2 courses income and substitution effects are examined. The textbook identifies each as follows:

Income effect – higher real wages might persuade people to work less hours and enjoy extended leisure time (see graph – SS2).

Substitution effect – people have an incentive to work extra hours because the financial rewards of working are raised, and the opportunity cost of not working has increased (see graph – SS1).

Work-life balance is typically discussed as a personal issue and again Germany has been leading the way:

1960 – average West German working year = 2,163 hours
2018 – average German working year = 1,363 hours

Furthermore once they leave work in the mid afternoon a lot of them are actually free of the office and more importantly emails. Daimler automatically erase emails to employees who are on holiday.

Workaholic countries slowing down

Countries that are renowned for working long hour – South Korea, China and Thailand – have already limited school homework. South Korea wants to reduce average annual working hours to less that 1,800 from 2,069 in 2016 – the most for any OECD high-income country.

Average wages are not above pre-crisis levels in all developed countries except the UK and Greece. The eurozone’s jobless rate is the lowest and US wage growth the fastest since 2009. Shorter hours won’t help the poorest paid workers, who can’t afford to work less but for the broad middle in rich countries a new working life is emerging. It could look like Germany – shorter workdays, high productivity and yoga.

Source: Why the 30-hour week is almost here – Simon Kuper – FT Magazine February 15 2018

The NAIRU in New Zealand

Below is an extract from a RBNZ paper from March this year on Estimating the NAIRU and the Natural Rate of Unemployment. Especially useful for A2 students.


The headline unemployment rate in New Zealand has been trending down over time. This fall in the unemployment rate has not been accompanied by a rise in inflation, suggesting that the underlying natural rate and the NAIRU may have also declined through time. In this section, we document some of the changes in the New Zealand economy that have influenced the unemployment rate over history.

As a first step, we disaggregate the unemployment rate into three sub-components as follows:

a. Cyclical unemployment results from changes in aggregate demand conditions over the course of a business cycle. As firms experience weaker demand, existing workers may be laid off and fewer new workers will be hired.
b. Frictional unemployment refers to the regular short-term churn in the labour market, both within, and in and out of, the labour force. It is determined by the efficiency of the matching process given the diversity of job-seekers and vacancies.
c. Structural unemployment represents a more fundamental mismatch between those hiring and job seekers given their skills and geographic location. This could arise from long-lasting changes in the structure of the economy such as socio-demographic trends, technological change, or a rapid change in the mix of industries.

The lines between these categorisations can be indistinct. For example, some argue that a prolonged period of cyclical unemployment could also lead to hysteresis effects that could spill over to structural unemployment. For example, an extended period of unemployment may lead to an erosion of human capital making workers less attractive to employers and hence reducing their bargaining power. In principle, frictional unemployment and structural unemployment should be captured by the trend in the NAIRU or the natural rate, as both forms of unemployment may continue to exist even if the labour market is in equilibrium. This is because those that are structurally unemployed may not be easily drawn back into employment despite an increase in labour demand and an upward adjustment in wages. In addition, the level of frictional unemployment is largely determined by the efficiency with which potential workers and employers can find jobs. In contrast, cyclical unemployment captures when the labour market may be operating below capacity as a result of a shortfall in demand.

Monetary policy has little influence over the level of frictional and structural employment. These are largely determined by the evolution of technology and the obsolescence of skills, and by structural policies to facilitate the acquisition of new skills and improve the match between employers and job-seekers. For example, policies that affect the cost of hiring (e.g. employment protection laws), the incentives for job finding (e.g. unemployment insurance), or the bargaining power of workers (unionisation and labour contract laws).

In Figure 3, we decompose the pool of unemployed workers on the basis of unemployment durations. In particular, we categorise those who have been unemployed for less than 4 weeks as contributing to frictional unemployment, 4 to 52 weeks as cyclical unemployment, and greater than 52 weeks as structural unemployment.

New Zealand’s Phillips Curve 1993-2017

Bill Phillips (a New Zealander) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850’s to 1960’s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. The downward-sloping Phillips curve is apparent in the graph below which plots core inflation against headline unemployment for New Zealand.

There has been also an apparent shift inwards of this relationship where lower rates of unemployment have become possible for a given level of inflation, particularly relative to the 1990s. The simple plot in the graph does not take into account other factors such as changes in import prices, inflationary expectations and capacity constraints which also have the potential to shift the Phillips Curve. These are discussed further below:

1. The price of imports. As the price of imports increase whether it is raw materials or finished products, the price of local goods become more expensive which increase the general price level. Also if a country finds that its exchange rate depreciates the price of imports rises. Oil is a very inelastic import and with a barrel of oil below $30 in 2016 there was little pressure on the CPI. Where inflation has been higher is in those countries that have withdrawn price subsidies and also had sharply falling currencies – Argentina 24% and Egypt 32%.

2. Public Expectations. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves. In Japan firms and employees have become conditioned to expect a lower rate of inflation. Prime minister Shinzo Abe has called for companies to raise wages by 3% to try and kick start inflation.

3. Capacity pressures. This refers to how much ‘slack’ there is in the economy or the ability to increase total output. If capacity pressures are tight that means an economy will find it difficult to increase output so there will be more pressure on prices as goods become more scarce. Unemployment is the most used gauge to measure the slack in the economy and as the economy approached full employment the scarcity of workers should push up the price pf labour – wages. With increasing costs for the firm it is usual for them to increase their prices for the consumer and therefore increasing the CPI. However many labour markets around the world (especially Japan and the USA) have been very tight but there is little sign of inflation. This assumes that the Phillips curve (trade-off between inflation and unemployment) has become less steep. Research by Olivier Blanchard found that a drop in the unemployment rate in the US has less than a third as much power to raise inflation as it did in the mid 1970’s.

This flatter Phillips curve suggests that the cost for central banks in higher inflation of delaying interest-rate rises is rather low.

Wages in the English Premier League – Demand-Pull Inflation

You are no doubt are well aware of the staggering wages that the English Premier League player receive especially when you consider other occupations.

What ultimately the salary explosion has been driven by the huge amounts of money that is now at the disposable of some of the top clubs. In economics this refers to the concept of demand-pull inflation where the supply has not kept apace with the demand for world-class players. Below is graph showing both demand-pull and cost-push.

Volvo Ocean Race and the Multiplier Effect.

I am quite an avid watcher of the Volvo Ocean Race with the daily race updates and the excellent graphics on their website – currently they are in Auckland before setting sail for Itajaí in Brazil. Most days they have news on the current positions of the yachts and who has made gains and losses in the last 24 hours. A recent race update dealt with the economic impact that the race has had on the Spanish economy and it just happens that I am covering the multiplier with my A2 Economics class.

The Multiplier Explained

Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are ultimately purchased will experience an increase in their incomes. If they in turn, collectively spend about 3/5 of that additional income, then $180m will be added to the incomes of others. At this point, total income has grown by ($300m + (0.6 x $300m). The sum will continue to increase as the producers of the additional goods and services realise an increase in their incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be ($300m + (0.6 x $300m) + (0.6 x $180m). The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.

The value of the multiplier can be found by the equation ­1 ÷ (1-MPC)
You can also use the following formula which represents a four sector economy
1 ÷ MPS+MRT+MPM

Source: CIE Revision Guide by Susan Grant

Impact of Volvo Ocean Race on Spanish Economy

PriceWaterhouseCoopers (PwC) conducted a study measuring the impact of the Volvo Ocean Race on the Region of Valencia and Spain. Some their findings are:

  • The impact in the Region of Valencia has grown to 68.6 million euros in GDP and 1,270 full-time equivalent jobs.
  • Hotels, restaurants and local business were the sectors to benefit the most.
  • Alicante received 345,602 visitors from October 11 to 22, 2017, (10.3% more than in 2014-15 and 17.6% more than in 2011-12).
  • The Volvo Ocean Race had a significant positive effect on national tax revenue, adding more than 41 million euros.
  • The media value directly linked to coverage mentioning the Alicante brand over the period of the race start exceeds 36 million euros.

The Volvo Ocean Race 2017-18 has added 96.2 million euros to the Spanish Gross Domestic Product (GDP), an increase of 7.6% over the 2014-15 edition. The race also generated the equivalent of 1,700 full time jobs in Spain, according to an economic impact study delivered by PriceWaterhouseCoopers (PwC) measuring the impact of the Volvo Ocean Race on the Region of Valencia and Spain.

The impact in the Region of Valencia grew to 68.6 million euros of GDP, a 3.3% increase on the 2014-15 edition. The sectors of activity that benefited the most were local businesses and restaurants, each by more than 10 million euros. In terms of employment, the equivalent of 1,270 full-time jobs were generated, a figure similar to the last edition.

The PwC study estimates a positive effect on tax collection in Spain of more than 41 million euros as a result of an increase in economic activity and employment generated by the Volvo Ocean Race 2017-18.

The actual value of the multiplier is not mentioned in the report but from all accounts the Volvo Ocean Race has had a very positive impact on Valencia.