Eco Today - Mar10:ET Master Page 2007 - ASKnLearn

A reduction in interest rates also makes it cheaper
for businesses to borrow which should help to
promote investment. However, a lack of business
confidence might make firms unwilling to invest
especially if they consider that the recovery will be
very weak. Another important issue affecting both
consumption and investment is the unwillingness of
banks to lend as they try to rebuild their capital.
Price
Level
PL2
PL1
AD
AS2
AS1
Another way by which lower interest rates might help
to close the output gap is via the exchange rate. Low
interest rates and the expectation that they will
continue make it less attractive for foreigners to
place cash balances in UK banks and more attractive
for UK citizens to place their cash balances in foreign
banks. Consequently, the demand for sterling will fall
and supply of sterling will increase causing its value
to decrease. This should make UK goods more
competitive since the foreign currency price of
exports will fall and the price of imports into the UK
will rise. However, despite a substantial fall in the
value of sterling, there has not been a significant
improvement in the UK’s trade in goods balance
because of slack demand in the UK’s export markets.
The above analysis explains why the Bank of England
has embarked on a process of quantitative easing.
This involves the Bank buying gilt-edged securities
from the market so increasing the supply of money.
However, it is, at present, uncertain about the
effectiveness of this policy.
(d) Illustrating your answer with an aggregate demand
and aggregate supply diagram, evaluate the likely
impact of an increase in commodity prices and weak
sterling on the price level and real output.
Once again evaluation is required and in this case it could
include a discussion of some of the following issues: the
magnitude of the changes; short run and long run effects; the
elasticity of the aggregate demand curve; and the significance
of import costs in total production costs. The following answer
provides a good response to the question and includes
relevant evaluation:
An increase in commodity prices will raise the costs
of firms. For example, copper used for plumbing in
new buildings will raise costs; while a rise in sugar
and cocoa prices will raise the cost of producing
chocolate. This rise in costs will be reflected in a
leftward shift in the aggregate supply curve. The effect
of ‘weak sterling’ is similar in that when the value of
the pound is low, the cost of imported raw materials
will be high. The following diagram illustrates the
impact on aggregate supply of the increase in
commodity prices and weak sterling. In turn, this will
cause an increase in the price level and a decrease in
real output, creating the possibility of ‘stagflation’.
The overall effect on the price level and real output
depends on how much the AS curve shifts which, in
turn, depends on the amount by which commodity prices
rise and the weakness of sterling. It also depends on
the elasticity of the AD curve: the more elastic it is,
the greater will be the impact on real output while
the effect on the price level will be less significant.
Y2 Y1
Real Output
However, there is a potential benefit of the low value
of sterling in that it will make UK exports more
competitive so causing an increase in aggregate demand
although this could also stimulate inflationary
pressures. The effect on inflation will be relatively
insignificant if the high commodity prices are only tem -
porary and if the value of sterling recovers during 2010.
(e) Apart from the increase in commodity prices, the
weakness of sterling and low interest rates, assess
two reasons why inflation might increase in the UK.
One factor is the fiscal deficit which is expected to
reach £178 billion for the year 2009/10. Part of the rise
in the deficit has been caused by a fiscal stimulus
(e.g. the cut in VAT from 17.5% to 15% in 2009 and the
increased public expenditure on training). This implies
that injections are considerably higher than withdrawals
so resulting in an increase in aggregate demand. In turn,
this would lead to an increase in the price level.
However, part of the increase in the fiscal deficit may
be explained by automatic stabilisers such as Job
Seekers’ Allowance, family tax credits and housing
benefits to those on low incomes. In other words, the
fiscal deficit has increased partly because of the
recession. If the process of quantitative easing
continues then the rise in money supply could,
according the Quantity Theory of Money, be inflationary.
The Fisher equation of Exchange MV = PY (where M is
the money stock, V is the velocity of circulation, P is
the price level and Y is output) suggests that a change
in the money stock will have a direct and proportionate
effect on the price level if the assumptions that V and
Y are relatively stable are correct. In practice, many
would suggest that V is not stable. Indeed, it fell
considerably during the recession. Further, Y is unlikely
to be constant since the economy is operating below
its full employment level.
A second factor is that high unemployment might not
deter inflationary wage demands. This may be explained
by ‘insider-outsider theory’. This theory assumes
that the firm and its employees ( ‘the insiders’ ) will
set wages without regard for the interests of
unemployed workers ‘outside’ the firm. Since it is
costly for the firm to replace ‘insiders’ with
‘outsiders’, the ‘insiders’ have bargaining power which
they can use to raise the wage above the marketclearing
level. It is possible, therefore, that wage
inflation could occur despite the rise in
unemployment, which is predicted to increase to
2.8 million in the UK by the middle of 2010. In
practice, wage inflation has been very subdued in the
UK and fell to less than 2% by the end of 2009.
M ARCH 2010 29