External Shocks and Economic Cycles
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This is a video recording of a live AS macro revision webinar that looked at some examples of external demand and supply-side shocks that can affect countries such as the UK. In the video I explained six key "shock absorbers" - ways in which a country might be better placed to cope with the impact of world demand, supply and financial shocks to their economic systems.β
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External Shocks and Economic Cycles
- 2. External shocks and UK economy β’ The UK is closely integrated into the wider global economy. Global developments affect the economic fortunes of the United Kingdom β’ External shocks can affect β’ Aggregate demand (C+I+G+X-M) β’ Aggregate supply (short run and long run) β’ Product markets (markets for goods and services) β’ Labour markets (employment and real wages) β’ Financial markets (supply of credit and cost of loans) β’ The scale of these shocks and their effects will vary β’ Key effect of an external shock is on confidence
- 3. -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 350 370 390 410 430 450 470 Real GDP for the UK Economy Growth, seasonally adjusted (%) Levels, seasonally adjusted (ΓΒ£ billion) Identifying Stages of the Economic Cycle Boom Slowdown Recession Recovery External economic shocks can bring about turning points in the business cycle Slowdown
- 4. Main categories of global shocks 1. World demand shocks. These are associated with a rise or a decline in spending and confidence abroad. 2. World supply/price shocks. These affect the global supply and prices of goods and services. 3. World financial shocks. These occur in the global financial system, such as increased stress in the international banking system or financial markets Key evaluation point: Not all shocks are necessarily negative β there can be some positive supply shocks resulting from advances in production technologies, newly international ratified trade and investment deals, political reforms
- 5. Most countries are vulnerable to international / regional external shocks Global Financial Crisis (GFC) Euro Zone Economic Crisis Volatile Commodity Prices China Slowdown International Trade & Investment Deals Currency volatility and policy changes e.g. devaluation Extreme weather events Geo-political uncertainty & terrorism
- 6. Shares of World Economic Output in 2015 16.86% 16.1% 7.11% 4.3% 3.39% 3.07% 2.9% 2.35% 2.34% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% China USA India Japan Germany Russia Brazil United Kingdom France ShareinglobalGDP(percent) Percentage share of the main industrialized and emerging countries in global gross domestic product (adjusted for purchasing power) in 2015 Note: Adjusted for purchasing power means that the $ value of each countryβs GDP has been adjusted to take account of differences in the cost of living in different nations. Using this measure, China in 2015 is now the biggest economy in the world although Chinaβs per capita national income remains a small fraction of advanced high-income countries such as the USA.
- 7. Evaluating the impact of a shock Chinese real economic growth slowed down from 7.3% in 2014 to 6.9% in 2015
- 8. Could a Chinese slowdown bring about a UK recession? Real GDP GPL1 Y1 AD1 AS Y2 AD2 GPL2 GPL UK trade with China is only around 4% of total trade in goods & services Chinese slowdown might actually increase Chinese investment into the UK Falling world commodity prices are a net benefit to a country such as the UK
- 9. Evaluating the impact of a shock Chinese real economic growth slowed down from 7.3% in 2014 to 6.9% in 2015 Direct effects on UK economy β’ Trade flows to and from China β’ Investment flows to and from China (FDI, Portfolio I) β’ Impact on jobs in the UK in industries directly affected β’ Impact on Sterling-Yuan exchange rate Indirect effects on UK economy β’ World commodity prices and global inflation β’ Impact on nations with whom the UK trades β’ Threats to globalisation / protectionism β’ Risk of increased currency volatility
- 10. Evaluating the impact of a shock Chinese real economic growth slowed down from 7.3% in 2014 to 6.9% in 2015 -30000 -20000 -10000 0 10000 20000 30000 40000 50000 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 The annual value of UK trade with China, Β£million Trade Balance with China Exports to China Imports from China
- 11. Shock Absorbers What are the main economic shock absorbers in a country such as the UK in the event of a deflationary global economic shock?
- 13. Monetary Policy Fiscal Policy Flexible Labour Market Flexible Product Markets Shock Absorbers Deflation risk: Bank of England might cut interest rates to 0% or expand their QE programme
- 14. Base Interest Rates and Mortgage Rates in the UK 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14 20 15 Effective mortgage interest rate Base rate The policy interest rate (base rate) is set each month by the Monetary Policy Committee. The 2% inflation target is set by the government. When the Bankβs interest rate changes, most other loan and savings interest rates in the financial markets will also change too . The Bank of England has left the Base Interest Rate in the UK unchanged at 0.5% since March 2009 β the lowest since the Bank was founded in 1694
- 15. Shock Absorbers Monetary Policy Fiscal Policy Flexible Labour Market Flexible Product Markets Deflation risk: Bank of England might cut interest rates to 0% or expand their QE programme Recession Risk Government might allow automatic stabilisers to work and relax fiscal austerity plans
- 16. Shock Absorbers Monetary Policy Fiscal Policy Flexible Labour Market Flexible Product Markets Deflation risk: Bank of England might cut interest rates to 0% or expand their QE programme Recession Risk Government might allow automatic stabilisers to work and relax fiscal austerity plans Risk to jobs UK has relatively flexible jobs market β real wages less rigid than 20 years ago
- 17. Shock Absorbers Monetary Policy Fiscal Policy Flexible Labour Market Flexible Product Markets Deflation risk: Bank of England might cut interest rates to 0% or expand their QE programme Recession Risk Government might allow automatic stabilisers to work and relax fiscal austerity plans Risk to jobs UK has relatively flexible jobs market β real wages less rigid than 20 years ago Risk to exports UK businesses need to look to export to other fast-growing regions of world
- 18. Floating Currencies 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Exchange rates for euro monthly average - sterling euro
- 19. Evaluating an external shock β’ Comment on the size of the shock e.g. an economic slowdown is not the same as a recession β’ Comment on the scale of the shock β Regional? Global? β’ What are the likely multiplier / accelerator effects? β’ Is the external shock likely to be temporary or more permanent? β’ Who are the main winners and losers? I.e. is the shock favourable or unfavourable to the country you are analysing β’ What are the opportunities and threats from a shock? β’ To what extent can economic policy respond? β’ Is a policy response likely to be effective?
- 20. Key policies to help absorb shocks Floating exchange rates (scope for a depreciation) Freedom to set / adjust monetary policy when conditions change Geographically and occupationally mobile / flexible labour force Strong non price competitiveness of domestic businesses A diversified economy (not over reliant on a few sectors) Strong fiscal position (stabilisation funds)