Economic Shocks and their Effects

A shock is an unexpected event that affects an economy. In this chapter we look at some of the shocks that hit countries at different points in time and how macroeconomic policies can be used to act as a shock absorber or stabiliser for an economy. Open economies and macroeconomic shocks The UK is an open economy meaning that a high (and rising) percentage of our national income and output comes from trading with the rest of the world; we are highly integrated within the global economy. From one perspective this increases the sensitivity of our economy to outside events for example a recession in key export markets will inevitably have downside effects on demand, output and employment in the UK. Changes in commodity prices have direct and indirect effects on our producers. However, trade and investment integration with other nations also provides opportunities to smooth our own business cycle depending on what is happening to cycles, exchange rates and policy changes elsewhere. Much rests on the flexibility of our economy to be able to absorb external shocks and bounce back when the opportunity arises. The need for a positive response has been highlighted by the world economic recession of 2008-09. Examples of shocks to the system! There have been many exogenous shocks to the UK over recent years some examples include: A deepening integration of China, India other emerging market economies plus the former Communist countries of Eastern Europe into the world economy. The ICT revolution in the mid-late 1990s and the dotcom boom-bust from 2000 onwards The emerging-market debt crisis and collapse of Long Term Capital Management in 1998 Terrorist attacks on the World Trade Centre and conflicts in Afghanistan and Iraq The quadrupling of world oil prices between 2004 and 2008 and huge rises in the prices of many other commodities such as gas, copper, precious metals The sharp fall in world oil prices during 2009 Rampant food price inflation in the global economy in 2007 and 2008 The effects of the 25% appreciation in sterling between 1996 and 1998 more recently a 25% depreciation in the value of sterling against the Euro. The tripling in house prices between 1997 and 2007 followed by the descent of the UK housing market into a steep recessionary period from 2008 onwards Substantial, and highly uncertain, inward labour migration flows into and out of the UK The contagion from the unravelling of the sub-prime mortgage crisis in the United States and the falling out the global credit crunch.

Exogenous shocks can be split into two main groups 1. Demand side shocks affecting the components of demand in one or more countries. 2. Supply-side shocks affecting costs and prices in different countries.

Demand Side Shocks Examples of demand-side shocks might include A capital investment boom e.g. a construction boom or rapid growth of spending on ICT A pre-election government spending spree or an unexpected reduction in taxation (e.g. the government opting for a fiscal policy expansion before an election) A significant rise or fall in the exchange rate affecting export demand and having effects on output, employment, incomes and profits of businesses linked to export industries A change in the rate of growth in one or more of the countries of our major trade partners which affects the demand for our exports of goods and services An unexpected cut or an unexpected rise in interest rates (i.e. a monetary policy shock)

Changes in aggregate demand brought about by a demand-side shock can create disequilibrium in the economy, which takes growth, prices and incomes away from their projected levels.
Inflation LRAS

P2

P1

P3

SRAS1 AD1 AD3

AD1

Y3

Y1

Y2 Yfc

Real National Income

Supply-Side Shocks There are many possible supply-side shocks to the global economy. Some of them prove to have beneficial effects, for example the emergence, adoption and take-up of a new technology arising from invention and innovation that has the effect of reducing cost for producers and prices for consumers. Often it takes several years for the full impact of supply-side shocks to become apparent and for their full significance to be recognised.

Inflation

LRAS

P2 P1

SRAS2

SRAS1 SRAS3 Aggregate Demand (AD)

Y2

Y1 Y3

Yfc

Real National Income

Examples of inflationary supply-side shocks include shifts in global food prices and also the world prices of oil, gas and other sources of energy. Shocks that bring about shifts in short run aggregate supply are illustrated in the diagram above. Supply shocks the global oil market The world prices of crude oil have been extremely volatile in recent years. In the summer of 2008 a barrel of crude cost more than $145 and there were fears of stagflation hitting oil-importing countries. By the start of 2009 the price had slumped to the $30 level before rising once more to settle between $55 and $65 a barrel. These notes below focus initially on the impact of higher oil prices. The macro effects of rising oil prices depend on several factors 1. The extent to which rising oil prices are temporary or more permanent. In general, the impact of higher oil prices will be larger the longer the price rise lasts. The possibility exists of super-spikes in oil prices - including the jump up to $145 in July 2008 these are short but sharp movements in prices driven higher or lower by speculative buying and selling. 2. Whether a country is a net importer or exporter of oil Britain was for many years a net exporter of oil but this has now changed because of the decline in North Sea oil production. 3. The extent of oil dependency of an economy i.e. the ratio of oil used per unit of national output produced. Some countries rely on high-energy industries and are exposed to volatile prices. 4. The extent to which oil users consumers can switch their demand away from oil towards alternative energy substitutes.

5. The effects of exchange rate changes e.g. the pound might rise against the US dollar which could absorb some of the effects of higher oil prices on the British economy since oil (and most other globally traded commodities) are priced in dollars. 6. The extents to which the labour market is flexible (will workers accept a cut in real incomes?) and the ways in which businesses react to higher oil costs can they absorb the higher costs and find efficiency savings elsewhere in their business?

Nymex crude oil

Light Crude Spot (WTI), Nymex, US dollars per barrel
150 150

125

125

100

100

USD/Barrel

75

75

50

50

25

25

0 00 01 02 03 04 05 06 07 08 09 10

Source: Reuters EcoWin

Main impact of higher oil prices on the UK economy 1. A fall in aggregate supply and higher inflation: A higher oil price causes an inward shift in SRAS and is an example of an exogenous inflationary shock. The effects on inflation can be increased if wages follow prices following a rise in inflation expectations. 2. Supply-chain effects: Higher oil costs work their way through the supply chain. So manufacturers and services such as airlines and utility companies pass on higher costs to wholesalers who do the same to retailers. Higher prices for consumers reduce their real purchasing power leaving less income available for buying other goods and services. 3. Slower economic growth: For oil importing nations, higher oil prices act as a dampening effect on the growth of real GDP. Consumption declines and businesses using oil-related products as inputs make less profit (because of higher costs) this can lead to a reduction in investment. 4. Jobs: Slower growth will hit jobs, not just in those industries that depend on oil but across the whole economy. Another effect of rising oil prices could be to erode business confidence. 5. A worsening of the terms of trade the terms of trade measures the relative price of imports compared to the prices that exporters receive for selling their output overseas. An oilprice increase leads to a transfer of income from importing to exporting countries through a shift in the terms of trade. For example the $140 per barrel price of oil provided a huge increase in profits for oil exporting countries leading to a sharp rise in their trade surpluses.

6. An increase in investment in oil substitutes a rise in actual and expected levels of oil prices will stimulate increased investment in substitutes for oil we have seen this with the growth of demand for bio-fuels, airlines investing in planes that have better fuel efficiency, and a rise in demand for alternative energy sources such as solar panels and wind farms. The danger is that volatile prices will worsen the economics of alternative sustainable energy sources. 7. A worsening of the UKs balance of payments in contrast to previous oil price shocks, the UK is now a net importer of oil. Oil prices and interest rates If oil prices cause inflation to accelerate, the response of the central banks including the Bank of England might be to raise interest rates to bring inflationary pressures under control. In reality, the situation is more complicated as our flow chart on the following page seeks to show. The Bank of England does not have a specific target for oil prices indeed the price of crude is only one part of a complex jigsaw of factors that they must consider when considering the likely path of inflation. CPI inflation did spike to over 5 per cent in the autumn of 2008 just a couple of months after the peak in oil prices. Since then oil and food prices have fallen helping to bring CPI inflation back down towards the 2% target level.

UK Inflation and Crude Oil Prices

Annual % change in the Consumer Price Index and Brent Crude price 150 150

USD/Barrel

100

Crude Oil Price

100

50

50

0 6.0 5.0 4.0

0 6.0 5.0 4.0

Percent

Consumer Price Inflation

3.0 2.0 1.0 0.0 3.0 2.0 1.0 0.0

Jan Apr

Jul 06

Oct Jan Apr

Jul 07

Oct Jan Apr

Jul 08

Oct Jan Apr

Jul 09

Oct Jan Apr Jul 10

Source: UK Statistics Commission and IPE

Higher oil prices the challenge facing monetary policy

Higher inflation 1st-round effects Risk of a wage-price spiral due to rising expectations

Policy response: Raise interest rates

Uncertainties: timing, magnitude & exchange rate effects Rise in oil prices Consumers: 2nd-round effects Real income falls Lower economic growth; Lower inflation pressure

What to do, and when?

Policy response: Cut interest rates

The evidence for the UK is that the volatility in crude oil prices is no longer as important in influencing the rate of inflation as it was in the past. Our oil-energy dependency ratio has declined and the flexibility of our labour and product markets has increased, which has the effect that pay is more flexible in response to changes in inflationary pressure. To add to this, many businesses have experienced a decline in their ability to pass on increases in their input costs when there are changes in raw material prices this is partly due to the fierce competition in many industries arising from globalisation. That said the surge in cost-push inflation caused by accelerating food and oil prices did contribute to the recession in the UK. Higher prices had a negative effect on peoples real disposable incomes and also fuelled a worsening in consumer confidence. Higher prices for essentials such as petrol and basic foods effectively acted as a tax on the consumer and hit lower-income groups hardest. Does the UK government benefit from high oil prices? The rise in world oil prices tends to have a direct effect on two important macroeconomic balances namely the balance of trade in oil and secondly the governments own finances. For countries such as Saudi Arabia, Russia and Norway all of whom are big net exporters of oil, the steep rise in the price of exports of crude oil has had an unambiguously positive effect on both their balance of trade and the health of government tax revenues. The huge sovereign wealth funds accumulated by the Russian and Norwegian governments are testimony to their desire to use some of the funds from oil exports to prepare for an economy beyond petroleum. For the UK the situation is more complicated. The economy is still a substantial producer of oil but since 2005 we have become a net importer of oil and the share of imported gas in meeting our energy requirements has also seen a sharp rise. And for the government higher oil prices are a double-edged sword. On the one hand, taxes from the profits of North Sea oil companies are expected to bring in 10bn this year a fiscal dividend from higher global crude oil prices. One can add in the extra tax revenues from dividends paid to UK-based shareholders of companies such as BP together with the extra income tax, VAT and other revenues from stronger growth in the UK oil industry. But on the downside, higher oil prices squeeze the profits of businesses that use oil as an essential input into production so they pay less in corporation tax and it also contributes to rising inflation and lower real household incomes, slowing down the economy and weakening the projected tax receipts heading the Chancellors way. Government spending too is affected by the higher price of crude oil. To take one example, it is estimated that the armed services will spend an extra 500m this year in transportation costs to meet their commitments around the world. That is a hefty increase in

spending little wonder that the pressure is on to reduce training times in aircraft and tanks. The queues to use aircraft and tank simulators will be getting longer in the months ahead. Source: Tutor2u Economics Blog

Supply shocks global food prices

The Economist Commodity Price Index

Index of Prices 2000=100 325 300 275 250 225 200 175 150 125 100 05 06 07 08 09 10 Food Industrial Metals 325 300 275 250 225 200 175 150 125 100

Index

Source: Economist Commodity Price Index

The years 2007 and 20008 witnessed a huge rise in global food prices that gave rise to the term agflation. This was another external shock to economies around the world. One of the major reasons for rising food prices was the rising global price of wheat with wheat prices rising 77% in 2007 alone. Many demand and supply factors were at work: Increased bio-fuel production: Concerns over oil prices, energy security and climate change have prompted governments to take a more proactive stance towards encouraging bio-fuels. This has led to increased demand for bio-fuel raw materials, such as wheat, soy, maize and palm oil, and increased competition for cropland. This led to a loss of resources targeted at the food chain and caused stocks of wheat to fall to a 30 year low. Declining stocks were also affected by the worst drought in Australia in 100 years, which halved the winter crop to 12 million tones in 2007. Desertification: Global warming and other environmental shifts are decreasing the quantity of available farmland by over 7 millions hectares a year especially on the African continent. If global warming continues water supplies could be disrupted leading to falling food production. Deforestation, soil erosion and exhaustion are examples of the Tragedy of the Commons. Speculation by investors: Wheat and other prices of commodities soared as they found favour among investors who were struggling with poor returns in other markets. On the demand side, rising incomes in emerging market countries also contributed to higher food prices. Per capita income has been rising in many emerging market countries and so too has demand for foodstuffs that have a strongly positive income elasticity of demand. An

obvious example of this is the demand for meat products a land-intensive product. Meat is more land intensive, because you need land for the livestock and crops to feed the livestock. Demographics: Demand has grown because of an expanding population - the global population is expected to rise from 6 billion in 2000 to 9 billion by 2050. Currencies: The weakness of the US dollar increased the purchasing power of speculators and other traders who can buy increased volumes of foodstuffs with currencies other than the US dollar driving market demand to even higher levels. Export controls: Some food exporters acted to limit their sales overseas so as to provide sufficient food for their own population. But whilst this helped to keep domestic prices in check it reduced supply on world markets forcing prices higher for food importers.

Index of real food crop prices, 2004=100. 2007 Real Prices Maize Wheat Rice Soybeans Soybean oil Sugar Economic consequences For the UK economy high food price inflation during 2007 and 2008 contributed to a surge in inflation. In the UK it led in part to inflation overshooting the 2% inflation target. Inflation peaked at an annual rate of 5% in the autumn of 2008. Inflation also accelerated within the group of countries inside the Euro Area and in many poorer developing nations. There are social and economic advantages from high food prices for example higher prices are an opportunity to improve farmers incomes and to stimulate investments in farming. For developing countries that are major exporters of food, the rise in world prices helped to bring about an improvement in the terms of trade and a strong balance of payments. That said higher food prices for domestic consumers created fresh problems of poverty. And most developing nations are also dependent on importing food and other primary commodities whose prices had surged. Social consequences of food price inflation 1. Regressive effects: Lower income families often spend a higher proportion of their budgets on food. Higher prices tend to hit them hardest causing a fall in real living standards. They are also least likely to be able to bid for a compensating rise in wages. This means that food price inflation can act like a tax on the poor and have a regressive effect on the distribution of income. High prices price the poor out of the food market. 2. Changes in diet: More expensive food bills might cause families to switch their spending towards cheaper mass-produced processed foods that are high in salt and sugar. Malnutrition can have damaging social effects including a rise in obesity, more people suffering from Type-2 diabetes and a worsening of educational performance in schools. 3. Deforestation and people forced off the land especially if countries give over more land to growing crops for bio-fuels. 4. Social unrest: High food prices around the world led to riots in many countries especially in those economies where agflation hit the real incomes of the urban poor whose spending on food far outstripped their spending on other items. Many have died because they have been unable to survive the rise in food prices; the World Bank called this effect the silent tsunami. Food price inflation and government intervention 141 157 132 121 138 135 2008 179 219 201 156 170 169 2009 186 211 207 150 162 180

Agflation brought a wide number of policy responses from countries around the world. They included: An increase in cash transfer payments to vulnerable households - putting extra strain on government spending and budget deficits Welfare payments have also included bread or grain subsidies specifically targeted to the poor and also rationing card systems to distribute subsidized wheat Rise in government spending on emergency food aid programmes and school feeding schemes Lower tariffs on cereal imports - the World Bank reported in 2009 that twenty-four of fiftyeight countries sampled had cut import duties and VAT in the wake of rising food inflation Introduction of maximum prices on bread, rice and dairy products (staple products) Using higher interest rates to control demand-pull and cost-push inflationary pressures Some countries including Indonesia have considered reintroducing grain buffer stock programmes to mitigate price volatility, despite the costs and problems of such policies during the 1980s and 1990s

Estimate of the impact of high food prices on poverty According to estimates from the World Bank, the increase in local food prices between January 2005 and their average level of 2008 may have increased extreme poverty by between 186 and 226 million people. It has revised its previous estimate and now says that 1.4 billion people live in poverty, based on a new poverty line of $1.25 per day.
Poverty numbers given food prices in 2008 (million) East Asia & Pacific Europe and Central Asia Latin America & Caribbean Middle East & North Africa South Asia Sub-Saharan Africa Developing Countries (All) Lower bound estimate 112 8 1 26 14 24 186 Upper bound estimate

133 9 2 37 20 26 226 Source: World Bank

Increasing food supply to control prices In the medium term the world needs a fresh round of supply-side improvements to hold down the pressure on food supplies and stop foodstuff prices spiking higher again. The World Food Organisation and World Bank want governments to improve producer incentives (including the removal of subsidies which benefit richer farmers more); invest in public goods such as science and research projects, food supply infrastructure and human capital; and strengthen institutions to support an attractive rural investment climate for men and women, including more access to rural finance, improved property rights, and greater opportunities for collective action by farmers; and policies to ensure a more sustainable use of natural resources.