Using the Income-expenditure Model in UK Economy - Essay Example

Using the Income-expenditure model examine the impact of the sharp fall in house prices in the next twelve months upon UK economy. An economy records all transactions that take place within the economy and such transactions express how much the economy produces. Gross domestic product (GDP) is a measure of the output produced by factors of production located within the economy. (Begg et al, 2000). GDP, also known as national income, can be measured in one of three ways, by output, income and expenditure. Measurement by either of these methods will produce identical results because theoretically: National income = national output = national expenditure. National expenditure can also be known as aggregate demand. Aggregate demand (AD) is the total planned expenditure on goods and services in an economy and consists of consumption (C), investment (I), government expenditure (G), exports (X) minus imports (M). Therefore: AD = C + I + G + (X – M) This essay analyses the impact of declining housing prices on the national economy with the accent made on the aggregate demand. However firstly homage will be paid to the factors of AD Consumption refers to the use of goods and services by consumer purchasing or in the production of other goods. Investment is referred to as an addition to the real capital stock of the economy and it comprises the purchase of new capital equipment, the construction of buildings and the addition to the stock of raw materials, semi-finished goods and finished goods. Economists refer to investment as spending by firms (Ison, 1996) Government expenditure is the existing spending by central government and local authorities on the provisions of social goods and services such as, health, education, roads etc, marketed goods and services such as coal, postal services, etc and transfer payments e.g., child benefit, job seekers allowance, state pension etc. Government expenditure is primarily financed by taxation and borrowing. (Pass et al, 1998). Exports are goods and services produced in the UK and are purchased by foreigners, the purchase of exports adds to the income of UK households and firms. Exports therefore provide an injection into the economy. Imports can be classed as a leakage from the economy as it represents the amount of money spent on goods and services that are purchased outside the home economy. It leaks out of the circular flow and forms part of the demand for output from foreign countries. (Ison, 1996). A change in any of these constituent variables of the aggregate demand will result a change in the overall aggregate demand. There was a high GDP growth reported in the UK in the recent years, largely stimulated by a constant increase of housing prices. The time has come for a cool down, as unreasonably high house prices begin to decline. Although the housing industry did not experience a crash, it is recessing now, and it is expected that this trend will continue for the next 12 months. Private consumption, investment, government spending, imports, and exports — all the components of aggregate demand are analyzed explicitly below. At first let us look at the factors unaffected, or slightly affected by the decrease of house prices. Here we start from exports which are largely influenced by changes in the world economy rather than national activity. Hence lowering house prices will not produce any effect on exports. Secondly we address government spending, since it is determined by the political processes it is also likely to remain unchanged. Nevertheless it would be reasonable to note that political battles heat up with the economic recession announced. So there may be a slight increase in government expenditure as the struggles for power intensify, heated by the economy slowing down. The most directly affected component of aggregate demand is the private consumption. Changes in house prices affect the economy through a number of channels. The most obvious is through their effects on households and three additional factors: interest rates, net wealth, and consumer confidence. Let us analyse each of the mentioned aspects. One would assume that Net wealth is positively affected by the decline in housing prices due to fewer funds needed to pay for housing services, consumers in effect would have more funds left for spending. However this is not the case. The situation in the UK with respect to housing is that it manifest as the households primary asset, due to house ownership within the UK being so widespread. This is a sensitive predicament owing to house prices rising and falling thus exposed to a considerable amount of risk With house pricing falling, spending will be decrease on every level of income, leading to the whole C line shifting downwards (see Figure 1). House prices form the main part of individuals wealth, thus a lower house price concludes lower wealth The impact of the increased net wealth due to lower housing prices on the consumer spending Figure 1 illustrates that function C is affected by falling house prices in a negative manner, causing less spending and thus a shift in the position of C. Note that although there will be spending and the wage amounts will be largely the same as when house prices were high, there is merely an added level of anxiety and fear associated with lower house prices, causing home owners to place a larger amount into saving, which aids in their feeling of security and thus consequently reduces the amounts of spending in all respects, specially on extravagant holidays, home improvements, luxury cars etc. This will affect many areas of the economy, hence government reacting in an appropriate manner to encourage and restore faith in spending. Attached to net wealth there is the notion of, a fall in house prices having a knock on effect on the amount available to borrow i.e. Households have less collateral to borrow against. Mortgage lenders do allow home owners to borrow some of the capital gain that has built up on their property, However reduced equity on the property due falling house prices will cause no or reduced borrowings in the form of mortgage equity withdrawal. An added concept to this is individuals who borrowed while house prices were high on the basis of added equity to their properties, will consequently continue to pay against a probable high interest rate, on an equity that is no longer there. Consumer confidence will experience a more complex effect from the decline of house prices. On the one hand, cheaper houses will increase public confidence as people with lower levels of income able to now buy their own houses or engage in mortgage. There is however a negative second hand, the above mentioned effects on net wealth will also have a considerable downturn on consumer levels of spending, borrowing and investing as a result of a bruised consumer confidence. Lowering house prices is also an indicator of economic slowdown. Nevertheless, the end of the continuous rise of house prices is also the end of a high inflation rate: “The UK housing market is the Bank of England’s top gauge for inflation in the UK.” (Refco FX 2005). Therefore with the future stability promised and house prices lower consumer confidence will raise. Finally, the interest rates are used by the Bank of England as regulation tool for housing prices. With the decline of home prices it will also lower the interest rates, but not drastically (Musa, 2005). Interest rates have a substantial influence on consumption an investment. Some forms of expenditure are particularly sensitive to such change (Fuller 1990). Large items of consumer expenditure, such as cars and household goods, are often bought on credit. Lowering interest rates makes the cost of borrowing cheaper and therefore, has the effect of making such goods cheaper to purchase on credit. (Heather, 1997) This will therefore lead to an increase in demand and thus an increase in consumption and hence an increase in aggregate demand. In turn this will lead to consumer spending increase over time as a result of reduced interest rates nd thus as a consequence lower savings. Note that the decrease will not be even for all income levels (see Figure 2). Diagram 2: The impact of lower interest rates on consumer spending Figure 2 “Current C” refers to the level of consumption at the beginning of falling house prices. “Future C” indicates consumption after interest rates decreased but falling house prices are still evident. The decrease in interest rates will also have an effect on savings. The level of savings in the economy is likely to decrease as there is less of an incentive to save and the return on savings is lower due to the cut in interest rates. Therefore as saving decreases, people are more likely to spend instead, therefore increasing consumption, and again increasing the aggregate demand function. The next aspect affected by the change of housing prices is investment. It is influenced indirectly, through consumer confidence and discount rate. As the attractiveness of the housing market falls with the prices and discount rates it does not pay to invest into housing on a short term. However, on the long term with the consumer confidence high enough and discount rates stabilizing the house prices will rise as the economy will enter its upswing. Investment is mostly short-term oriented so there is a decline expected, although the most wise and forward-looking investors will benefit from placing funds into housing today. Fiscal policy is the use of taxation and/or government expenditure to achieve a number of aims; in this case it would be to increase aggregate demand. An increase in government expenditure can also create a rise in the aggregate demand function. By spending more on government projects such as investment into the NHS and improving education systems, the government can create more jobs. Consequently this should increase consumption as more of the labour force will be employed and with greater amounts of personal disposable income. The government can also subsidise companies to produce more. Both measures should increase aggregate demand and bring actual output closer to potential output Imports depend on two factors affected by housing prices: exchange rate and the condition of domestic economy. While the first factor will lower the import due to the decrease of housing prices reducing the inflation rate of GBP, the second one will stimulate more imports, as the national economy growth in future is forecasted to be slower than now. The slight changes in interest rates will be followed by only a slight decrease of inflation, so it is more likely that the amount imports will rise pushing the pound further down. Furthermore reducing imports can increase aggregate demand. Since any part of consumers’ income spent on the purchase of imports reduces the amount spent on domestically produced goods and services, switching demand away from imports can raise aggregate demand and therefore employment. However although increasing consumption and decreasing taxes may seem easy politically, they do have problems. The policy may lead to a deficit in the government’s budgetary position and thus oblige the government to borrow. (Heather, 1997) Additionally, there are two main risks for the monetary policy avoided with housing prices cooling down. The first one is an industry crash. Analysts expected that unreasonably high house prices which were increasing during the last years (see Figure 3) could lead to rapid decline when the margin between the real house prices and expected house prices would become too large. The decline of house prices helps to avoid this risk. The second risk lies within the assumption that house prices rising constantly and unreasonably will no longer aid consumption as much as in previous years. “For example, households are now more willing to refinance their mortgages at a given interest rate savings because refinancing entails lower fixed costs and fewer hassles than in the past.” (Duca, 2005) Since the prices no longer help consumption it is better to lower them. Figure 3: Real house prices against trend (Farlow, 2005) Thus we can summarise that the change of the aggregate demand will be negative, affected by the increase of imports, decrease of investments and mitigated by the consumer spending increasing slightly (increase of net wealth against the decrease of interest rates). The national economic growth is lowering but not unwelcome. Cooling down is just a part of an economic cycle (see Diagram 5). On the Diagram 4 below, one can see that the previous high rate of aggregate demand was higher than the production rate in housing industry leading to a disbalance of output/income. The future position will be closer to economic equilibrium. Diagram 4: The change of aggregate demand leading to output/income equilibrium The point at which the AD curve intercepts the 45º line, is the only point at which aggregate demand is equal to output — economic equilibrium. The line at 45º line will have the same value on the horizontal axis as on the vertical axis. This is because it is intended to show that the value of output must equal the value of planned expenditure for an economy to be in equilibrium. The economy is in equilibrium because the amount people which to purchase equals the amount firms wish to produce. (Heather, 1997) During previous years British economy was overheated, and the aggregate demand was higher than now, expecting a higher production rate to equal the demand at the equilibrium point. However the production could not keep up with the increase of demand leading to a disbalance. The decrease of the aggregate demand lowers the equilibrium point as can be seen from Diagram 4. Moreover, there is a known multiplier effect from the decrease of aggregate demand: for example, while it decreases only by 200, the output/income equilibrium point falls by 400 (Diagram 4). Therefore in this case, the multiplier is 2. Thus the change in aggregate demand is always followed by the change in equilibirum output with respect to multiplier effect, which can be calculated as 1(1–MPC), where MPC is a marginal propensity to consume representing the proportion of an aggregate raise in pay that is spent on the consumption of goods and services, as opposed to being saved. Diagram 5: The start of the downswing of the British economic cycle References Duca, J.V. (2005). Making Sense of Elevated Housing Prices. SouthWest Economy, September/October, Iss.5. Farlow, A. (2005). Housing, Consumption, and the Economy: Why Do House Prices Become Misaligned, and What Are the Consequences? Guest Lecture, London Business School, June 2. Mussa, M. (2005). Global Economic Prospects: Growth Slowing Below Potential in 2006. Institute for International Economics. Refco FX. (2005). All about the Majors: GBP/USD. Retrieved December 29, 2005 from http://www.refcfx.com/education/currency-pairs/majors-gbp-usd.html David Begg, Stanley Fischer, Rudigar Dornbusch (2000), Economics, 6th Edition, Mcgraw-Hill, United Kingdom Stephen Ison (1996), Economics, 2nd Edition, Pitman publishing, Great Britain Christopher Pass, Bryan Lowes and Leslie Davies (1998),  Dictionary of Economics, 2nd Edition. Unwin Hyman. United Kingdom. Neil Fuller (1990) Fundamental Economics, Hodder and Stoughton, United Kingdom Ken Heather (1997) Understanding Economics, Prentice Hall, Great Britain. Jack Nobbs and Ian Hopkins (1994) Economics, a core text, 4th edition. Mcgraw-Hill, United Kingdom Read More