Hi guys. As promised, here are some of the answers I came up with from the class today. Any question, please use the comments box below. Please use your handouts to find the questions to this.
a) i) Labour productivity is defined as the units of output produced per unit of factor input in a given period of time – in this case labour is the factor input in question. This can be measured in terms of volume of units to number of factor inputs, or alternatively the value of units. In the extract, it seems that the USA’s labour productivity has increased over the time period, but the UK and EU experienced productivity falls in the period 2007 – 2009.
a) ii) One reason labour productivity declined is due to the fall in demand for goods/services. The recession meant employers were selling less goods, hence the volume of goods to be made wasn’t as much.
Another reason could be because of the lack of investment in the recessionary period. Lack of investment by firms means they’re less willing to take on workers and train them. This could contribute to low labour productivity.
a) iii) Declining productivity could mean reduced international competitiveness. Reduced productivity can increase the costs of production for firms, which means that prices are likely to be increased relative to the rest of the world. This could increase the value of imports purchased relative to the value of exports sold (therefore, a decrease in net exports). In turn, this would mean a worsening of the current account deficit due to the worsening of the trade balance.
Due to the effects above, it could mean that economic growth slows, as AD is likely to decrease due to the increase in leakages out of the circular flow of income (as net exports are likely to fall). Therefore, domestic spending is probably going to fall (ceteris peribus) and therefore GDP will also follow. What’s more is that unemployment is likely to rise, namely cyclical unemployment. Demand for labour is a derived demand from the demand for goods and services, therefore unemployment is likely to rise because this type of unemployment occurs due to demand deficiency.
Another possible consequence is cost push inflation – business costs can rise due to the costs of production rising and therefore this can cause employers to raise prices. Prices domestically could also increase, meaning an increase in the cost of living and a strain on society’s poorest. This could worsen equality in society.
However, declining productivity may not be all bad for the economy. Firstly, it depends on the magnitude of the decline in productivity. If it is a relatively small amount, then the negative effects on the economy are likely to be limited. Also, there are other factors to consider other than productivity which could boost economic growth and increase employment. The other thing to consider is the duration of the fall in productivity. In the extract, we can see that the fall is likely to be short-lived due to the 2 year time period which happens to be in the recession. The other time period in the extract shows a net gain in productivity over a long period of time.
Furthermore, it is not safe to assume that demand for UK products only comes down to price factors. There are also non-price factors to consider, such as quality of product and expertise. The UK still specialises and therefore has comparative advantage in certain services, most importantly financial services and pharmaceutical products.
b) i) In the extract, Mr King mentions that the biggest risk to the UK economy is the financial health of our major trading partners. In a more globalised world, this is becoming more and more true and the UK just so happens to trade significantly with the EU (60% of our exports). If the economic well-being of the UK’s trading partners is at risk, then it is likely that demand for UK products will fall, which could increase the trade balance deficit, hence the current account deficit. This could, in turn, increase unemployment in the UK as less labourers are demanded by firms to output products.
We can show this on an AD/As diagram, where AD shifts to the left, causing real gdp to fall and general price level to fall. Although, in reality it is unlikely that prices will fall because there are many other factors to consider, if the effect is big enough there could be some deflationary risks.
b) ii) One factor that can increase investment is an increase in real GDP of a country. This is due to the accelerator effect. If firms see investment opportunities as profitable, then they are more likely to invest. If a country’s GDP is rising, it is an indicator that income are rising and so is spending. Therefore, firms are more likely to invest in countries that are doing well in terms of their income, spending and output.
The second factor that could increase investment is the interest rates that are being offered by banks. Firms often require large loans to invest into capital goods and increase their stock of capital. Therefore, if interest rates are lower, firms are more willing to invest more due to the cost of loans going down. Hence thereis less risk for firms when borrowing large amounts of money.
b) iii) Investment expenditure makes up part of a country’s aggregate demand (C + I + G + (X-M)). In fact, it is the second largest component of aggregate demand in the UK. Investment is defined as the money spent by firms on capital goods. It has the effect of increasing aggregate demand and increase long-run aggregate supply as more capital goods and better trained labour can increase productive potential in an economy.
Investment also happens to be an injection into the circular flow of income. In order for the economy to grow, injections must outweigh leakages, as taught in the circular flow of income model. Therefore, as long as other injections are high, it is likely with enough investment GDP will grow. As you can see from the extract, investment is positively correlated with GDP growth throughout the time period. When investment is positive, GDP is also positive. In 2008, when firm investment falls by 5%, GDP falls by 0.1%.
Investment is also particularly important as it triggers off the multiplier effect due to it being an injection into the circular flow. This means that investment income of £1 billion, for example, can generate more than £1 billion in GDP for the economy. This is because the investment expenditure does not disappear – instead it circulates the economy in rounds until it is finally leaked out by other economic activities. Therefore, it can really help an economy in time of recovery.
Another attribute of investment is its positive effect on productive potential. Increased productive potential is good because it helps to keep inflation low. Please see this on the AD/AS diagram. Increased LRAS causes inflation to fall, which is a good thing in terms of price stability, as long as demand is not deficient. This positive effect to inflation is called disinflation, which is not to be confused with deflation which is due to lack of demand in an economy.
However, while investment may be very beneficial for an economy it does depend on a few things. Firstly, it depends on the magnitude of the investment expenditure. If investment expenditure rises by a small amount, then the positive effects on the economy are limited. Secondly, it depends on the duration the investment expenditure is increased for. A short-term boost to investment will not see an economy’s GDP improve by so much.
Another thing to consider is that in the data it seemed that there was a positive correlation between investment and GDP. This may be true and easy to assume, but there are many other factors to consider in the real economy. This correlation may be purely coincidental.
As investment is an injection into the circular flow of income, the effects of this expenditure really depends on the level of consumer confidence also, as household expenditure drives money round the economy and gives confidence to firms to invest more. Therefore, it is important that households are also confident in a time of higher than average investment.
Overall, investment is definitely a good thing for the economy. It allows more spending and income to occur with more productive potential. Without investment, consumers would just spend and nobody would produce anything, which in turn is unsustainable in the long-term.
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