Economic Policy and Economic Evaluation of the United Kingdom 2005 - 2015

Table of contents

Table of figures

List of abbreviations

1 Introduction

2 Economic Growth - GDP
2.1 GDP of the United Kingdom 2005-2015

3 Price stability - Inflation rate
3.1 Inflation rate United Kingdom 2005-2016

4 Unemployment
4.1 Unemployment UK
4.1.1. Okun’s Law UK

5 Balance of payments - Current account balance
5.1 Current account balance UK

6 Other macroeconomic indicators
6.1 Exchange rate
6.2 Openness
6.3 Debt to GDP

Conclusion

List of References

Appendix

Table of figures

Image 1 GDP per capita UK (2005-2015)

Image 2 GDP per capita (USA, UK, GER, EU)

Image 3 Influence of Brexit uncertainty on GDP growth

Image 4 Inflation rate UK (based on CPI) 2007-2016

Image 5 Inflation rate & Base rate UK 2003-2016

Image 6 Unemployment rate - seasonally adjusted data (EU, GER, UK)

Image 7 Grwoth rate (Okun's law) 1980-2016

Image 8 Growth rate 1980 – 1991

Image 9 Growth rate 1992-2000

Image 10 Growth rate 2001-2007

Image 11 Growth rate 2008-2016

Image 12 Current account balance % of GDP UK

Image 13 CAB UK 2007-2015

Image 14 Exchange rate UK sterling 2015-2016

Image 16 Debt to % of GDP (UK, GER)

Image 17 GDP - Annual growth rate (USA, Germany, UK, EU)

Image 18 Composition consumer price index UK

Image 19 Inflation rate (USA, GER, UK, EU)

Image 20 Current account balance % of GDP (GER, US, UK) with trend line

Image 21 Current account balance as a share of GDP - UK

List of abbreviations

illustration not visible in this excerpt

1 Introduction

In a globalizing world with increasing international trade and growing markets as well as crisis influencing countries worldwide, it becomes ever more important to evaluate and compare the economic performance of different nations as well as their impacts on each other.

One method that allows assessing a country’s macroeconomic performance is the “magic square” according to Kaldor (1971).^[1] This approach takes four variables into consideration, which should be pursued amongst an economy:

1.Sustainable growth,
2.Equilirium of balance of payments,
3.Price stability,
4. High employment.^{[2] [3]}

In the following paper the economic progress of the United Kingdom within the previous 10 years should be evaluated using the magic square as a framework. Therefore, there will be a main focus on the most relevant macroeconomic indicators, such as growth of GDP, inflation rate, unemployment rate and current account balance, in order to provide a sound overview regarding UK’s overall economic development.

2 Economic Growth - GDP

The GDP is used to calculate the monetary value of all goods and services produced within a country’s geographic borders. It is usually determined on an annual or a more detailed quarterly basis.^[4]

The GDP includes consumer and public consumptions, government expenses, investments as well as the total net exports.

GDP=Consumption+Investment+Government+(Exports-Imports) (GDP = C + G + I + NX)

It is used as an indicator for a country’s economic performance and growth.^[5]

Since countries differ in size and population a GDP comparison between several nations is more accurate with using the GDP per capita, which indicates the relative performance of a country by dividing the real GDP by the number of people in the country. Additionally, this is also used as a gauge for the standard of living in a country.^[6]

2.1 GDP of the United Kingdom 2005-2015

Looking at the United Kingdom’s GDP for the last 10 years, one can identify some up and downs in the trend. Accordingly, to OECD data this is emphasized by the following graph, showing the UK’s GDP per capita for the time period of 2005 to 2015.

Abbildung in dieser Leseprobe nicht enthalten

Image 1 GDP per capita UK (2005-2015)

Source: http://data.worldbank.org/country/united-kingdom (accessed 12.11.2016)

With an exception in the years 2009 and 2010 the GDP increased steadily. In general, advanced countries are expected to grow between 1% and 4% annually.^[7] In most of the previous 10 years this aim was mostly reached, with an exception of the plunge in 2009 (-4.3%) and 2010 (-2.5%). The GDP plummet in those years can be easily explained with the financial crisis, which had a huge impact on the world’s economy. Therefore, a similar trend can be seen in the chart below and chart 1 in the annex, comparing the UK with data of the US, Germany and the European Union.

Abbildung in dieser Leseprobe nicht enthalten

Image 2 GDP per capita (USA, UK, GER, EU)

Source: https://data.oecd.org/gdp/gross-domestic-product-gdp.htm (accessed 12.11.2016)

Nevertheless, looking at the trend and figures it becomes noticeable that it took UK’s economy, compared to e.g. Germany or the US, a little bit longer to recover from the repercussions of the financial crisis. This may be explained with the economies strong dependence on the financial sector and center clustered in London.

Realizing a significant growth after recovering from the crisis, especially in 2013 (+3.8%) the economy slowed down a bit by reason of increasing uncertainty in regards to the “Brexit” referendum^[8], as illustrated in the figures hereafter.

Abbildung in dieser Leseprobe nicht enthalten

Image 3 Influence of Brexit uncertainty on GDP growth

Source: OECD Economic Outlook, June 2016, p. 228.

Business decisions were put on hold and international markets were increasingly evaluating the risk of a Brexit.^[9] The final decision pro Brexit in 2016 led to a downgrade of the forecasted growth by 0.1% to 3.4% (IMF) due to subsequent uncertainty.^[10]

However, despite the vagueness caused by the Brexit, the UK is still economically the second strongest country after Germany in the European union^[11].

3 Price stability - Inflation rate

Inflation is present when the general level of prices for goods and services (price index) is rising and hence the purchasing power of the currency is falling.^[12] Despite negative effects, a moderate level of inflation indicates a healthy economy.

Worldwide central banks of advanced economies pursue the aim to have an inflation rate of 2%, in order to achieve price stability in a country.^{[13] [14]} Thus, the currency today has almost the same value tomorrow, which enables customers and businesses to plan and make future decisions. Additionally, an inflation rate of around 2% encourages customers to spend money instead of saving. This is beneficial for economies, in terms of avoiding a Deflation-Downturn-Cycle.^[15] Therefore, the central bank is in charge of monitoring and regulating the inflation rate, by e.g. hiking up the base rate.^[16]

3.1 Inflation rate United Kingdom 2005-2016

Since the measurement of the inflation rate is based on the CPI, it is interesting to take a look at the composition of the consumer price index of the United Kingdom, as shown in the annex (2).

Looking at the UK’s changes in inflation rate, some huge fluctuations can be noticed.

Abbildung in dieser Leseprobe nicht enthalten

Image 4 Inflation rate UK (based on CPI) 2007-2016

Source: http://www.economicshelp.org/blog/5720/economics/inflation-stats-and-graphs/ (accessed 12.11.2016)

The chart is showing the 2% target on the one hand, and UK’s divergent inflation trend on the other hand. Especially notable are the two peaks in 2008 with a maximum of 5,2% inflation and in 2011 with another 5,2%. The spike in 2008 can be explained amongst others by a remarkable high oil price.^[17] Since the 10% of the CPI is generally directly depending on the oil price, it has a sizable impact on the inflation rate, as well.^[18] Usually, when the rate is that high (>2%) the bank of England, which is in charge of regulating inflationary processes, would be expected to raise the base rate to lower the amount of money in circulation and hence the inflation rate. However, worried by the financial crisis and the depth of recession the bank of England lowered the base rate down to 0.5% instead of raising it^[19], in order to further encourage customers and businesses to lend and spend money. This is emphasized it the following chart.

Abbildung in dieser Leseprobe nicht enthalten

Image 5 Inflation rate & Base rate UK 2003-2016

Source: http://www.economicshelp.org/blog/5720/economics/inflation-stats-and-graphs/ (accessed 12.11.2016)

Crisis like the financial catastrophe normally lead to uncertainty and a lowering inflation rate down to deflation.^[20] Many countries experienced a deflation initiated by the crisis, whereas the UK’s inflation rate did not totally plunge. This shall also be elucidated by graph 3 of the annex, comparing the trend in Germany, US and the EU in total with inflationary developments in the United Kingdom.

The comparably slight fall of inflation in the UK might be explained with the bank of England taking precautions by lowering the base rate very early.^[21]

The increasing inflation rate up to its peak in 2011 can be justified by high oil prices, a devaluating pound and higher taxes.^[22] Especially noticeable is also the exceptional low rate in 2015 and 2016. This is mostly caused by an oil crash, lower energy prices, supermarket price wars, a negative output gap and low worldwide inflationary expectations, as Europe is experiencing a deflation, as well as uncertainty in regards to the Brexit.^[23]

4 Unemployment

Unemployment is often used to measure the health and performance of an economy. The most frequent method of measuring unemployment is the unemployment rate, dividing the number of unemployed people by the amount being in labor force.^[24]

In order to harmonize and being able to compare data the unemployment definition by the International Labor Organization (ILO) will be applied subsequently. Here unemployed people are defined as people, who want to work (being without employment at least for a year) and are available to work within two weeks, as well as at the same time actively seeking for employment.^[25]

4.1 Unemployment UK

Unemployment in the United Kingdom is already at an 11-year low, at the moment holding steady at 4.9%.^{[26] [27]} The total number of people unemployed decreased by 119,000 from 5.4% to 4.9% from a year earlier. The labor market is remaining strong. The total amount of people employed reached its peak in the first quarter of the year with record figures of 74.2%.^[28] The following chart summarizes the unemployment development from 2005 - 2016 and exemplifies UK’s solid labor market, as the figures are far below the EU average.

Abbildung in dieser Leseprobe nicht enthalten

Image 6 Unemployment rate - seasonally adjusted data (EU, GER, UK)

Source: https://www.google.de/publicdata/explore (accessed 12.11.2016)

As the trend shows the unemployment rate was also affected by the financial crisis in 2008. Unemployment increased by almost 3% from 5.1% in 2008 to 7.8% in 2009. Compared to Germany, where short time work was used to counterbalance the negative effects, it took the United Kingdom a bit longer to recover in terms of employment.^[29] Therefore, it is even greater to experience remarkably low rates since 2013.

However, the uncertainty caused by the Brexit will most likely lead to firms putting hiring decision as well as investment plans on hold.^[30] The Bank of England is expecting a rise in unemployment up to 5.5% due to the referendum result.^[31] So far the rate has stayed stable, though.^[32]

4.1.1. Okun’s Law UK

Looking not only at GDP and employment rate apart from each other, it makes sense to examine a country’s relationship between unemployment rate and GDP (=labor market & output) according to the Okun’s Law, which states that for every 1% increase in the unemployment rate a country’s actual GDP will be 2% lower than its potential GDP.^[33] Evaluating the diagram below, including the growth rate and change in unemployment, it becomes obvious that there is an inverse connection existing between unemployment and GDP.

Abbildung in dieser Leseprobe nicht enthalten

Image 7 Grwoth rate (Okun's law) 1980-2016

Abbildung in dieser Leseprobe nicht enthalten Abbildung in dieser Leseprobe nicht enthalten

Image 8 Growth rate 1980 – 1991 Image 9 Growth rate 1992-2000

Abbildung in dieser Leseprobe nicht enthalten Abbildung in dieser Leseprobe nicht enthalten

Image 10 Growth rate 2001-2007 Image 11 Growth rate 2008-2016

Taking a closer look at the trend line function 0.0218 can be translated into 2.18% potential growth rate in the United Kingdom. Additionally, the constant of -1,45 can be interpreted as a 1,45% increase of the real growth rate, as a result of the unemployment rate decreasing by 1%. Additionally, the correlation coefficient “R2” describes whether there is a strong or weak correlation between the indicators. In UK’s case the correlation is rather weak to medium (0,52), which indicates that there are probably other variables besides the development of unemployment causing progress of the growth rate and vice versa. Since there is an inverse relationship between unemployment and GDP in the UK, the Okun’s Law is confirmed in this case. However, United Kingdom’s example emphasizes that it does not have to be a 2% coefficient as according to the data it is a 1,45% in the UK, which is however still very close. Looking at the different time periods one can evaluate that the correlation mostly fluctuates between 6% and even 8%, with an exception in the years from 2001-2007, which can be explained by the GDP recovering, slowly after a small recession in 2001, whereas the fall of unemployment rate was lagged and started later in mid 2003.^[34] Especially, in the years of 2008-2016 countries worldwide had to struggle with the ramifications of the financial crisis. Therefore, the correlation between the indicators is remarkably higher and can be considered a strong correlation. Also the potential growth rate with 1,2% is lower then usually due to the global crisis. All in all, it seems that the relationship between the two meters holds and the Okun’s law can be generally confirmed in UK’s case.

Evaluating the connection between unemployment and growth rate is also often used to estimate the output gap, which describes the gap between potential and actual GDP.^[35] Therefore, e.g. growing cyclical unemployment might be a reason for widening the gap and decreasing an economy’s real growth rate.^[36]

5 Balance of payments - Current account balance

The current account is an important indicator regarding an economy’s health. Together with the capital account, it is the main component of a country’s balance of payments, which records the sum of all monetary transaction of a country’s residents with the rest of the world.^{[37] [38]}

Thus, the current account is calculated, as shown below:

CAD = Export of goods and services (X) – Import of good and services (M) + Net income abroad (NY) + Net current transfers (NCT)

Optimally, a nation’s current account balance should be zero. However, in reality this is very unlikely, instead countries have a surplus or a deficit, which indicates whether the country is a borrower (deficit) or a lender (surplus) to the rest of the world.^{[39] [40]} Since the trade balance normally forms the major part of the current account balance a deficit most likely indicates that the value of imports is greater than the value of exports (more money goes out than it comes in) and in terms of a surplus the other way around.^[41]

5.1 Current account balance UK

Abbildung in dieser Leseprobe nicht enthalten

Image 12 Current account balance % of GDP UK

Source: http://www.economicshelp.org/blog/glossary/current-account-bop/ (accessed 13.11.2016)

[...]

^[1] Index of Macroeconomic Performance for a Subset of Countries, Joanílio Rodolpho Teixeira, p. 527.

^[2] Prof. Dr. Köster, Bernhard. Lecture: EconomicPolicy_WS1617_IBM_2. Düsseldorf, 21. 10 2016, p. 18.

^[3] Index of Macroeconomic Performance for a Subset of Countries, Joanílio Rodolpho Teixeira, p. 527.

^[4] http://www.investopedia.com/terms/g/gdp.asp

^[5] http://www.investopedia.com/terms/g/gdp.asp

^[6] http://www.differencebetween.net/business/difference-between-gdp-and-gdp-per-capita/

^[7] Prof. Dr. Köster, Bernhard. Lecture: EconomicPolicy_WS1617_IBM_2. Düsseldorf, 21. 10 2016, p. 19.

^[8] OECD Economic Outlook, June 2016, p. 228.

^[9] OECD Economic Outlook, June 2016, p. 228.

^[10] https://www.imf.org/external/pubs/ft/weo/2016/update/02/

^[11] https://de.statista.com/statistik/daten/studie/188776/umfrage/bruttoinlandsprodukt-bip-in-den-eu-laendern/

^[12] http://www.investopedia.com/terms/i/inflation.asp

^[13] http://www.rechnungswesen-verstehen.de/bwl-vwl/vwl/Inflation.php

^[14] Prof. Dr. Köster, Bernhard. Lecture: EconomicPolicy_WS1617_IBM_2. Düsseldorf, 21. 10 2016, p. 23.

^[15] http://economictimes.indiatimes.com/definition/inflation

^[16] http://www.helpster.de/inflationen-bekaempfen-staatliche-massnahmen_220987

^[17] http://inflationdata.com/inflation/inflation/annualinflation.asp

^[18] Prof. Dr. Köster, Bernhard. Lecture: EconomicPolicy_WS1617_IBM_2. Düsseldorf, 21. 10 2016, p. 23.

^[19] http://www.economicshelp.org/blog/5720/economics/inflation-stats-and-graphs/

^[20] http://www.tradingeconomics.com/united-kingdom/inflation-cpi

^[21] http://www.economicshelp.org/blog/5720/economics/inflation-stats-and-graphs/

^[22] http://inflationdata.com/inflation/inflation/annualinflation.asp

^[23] http://www.economicshelp.org/blog/5720/economics/inflation-stats-and-graphs/

^[24] http://www.investopedia.com/terms/u/unemployment.asp

^[25] Prof. Dr. Köster, Bernhard. Lecture: EconomicPolicy_WS1617_IBM_2. Düsseldorf, 21. 10 2016, p. 25.

^[26] https://www.ft.com/content/953671ba-b784-37f6-8f29-45402e846d50

^[27] 2015-2016 Convergence program fort he United Kingdom, March 2016, p. 40.

^[28] OECD Economic Outlook, June 2016, p. 229.

^[29] Prof. Dr. Köster, Bernhard. Lecture: EconomicPolicy_WS1617_IBM_2. Düsseldorf, 21. 10 2016, p. 25.

^[30] https://www.ft.com/content/953671ba-b784-37f6-8f29-45402e846d50

^[31] https://www.ft.com/content/953671ba-b784-37f6-8f29-45402e846d50

^[32] https://www.theguardian.com/business/2016/aug/17/uk-unemployment-claimant-count-falls-after-brexit

^[33] The Labour Market and Output in the UK, Boris Petov, p. 8.

^[34] The Labour Market and Output in the UK, Boris Petov, p. 8.

^[35] https://www.researchgate.net/publication/284181856_The_Validity_of_Okun's_Law_An_Assessment_of_United_Kingdom's_Unemployment-_Output_Relationship

^[36] https://www.researchgate.net/publication/284181856_The_Validity_of_Okun's_Law_An_Assessment_of_United_Kingdom's_Unemployment-_Output_Relationship

^[37] http://www.investopedia.com/articles/03/061803.asp

^[38] Prof. Dr. Köster, Bernhard. Lecture: EconomicPolicy_WS1617_IBM_2. Düsseldorf, 21. 10 2016, p. 27f.

^[39] http://www.investopedia.com/articles/03/061803.asp

^[40] http://www.investopedia.com/terms/c/currentaccount.asp

^[41] http://www.economicshelp.org/blog/glossary/current-account-bop/