The Theoretical importance of manufacturing from an Economic Perspective
Both total and per capita output has risen for many decades in most industrial countries. These long-term trends have produced rising average living standards. In the UK the real value of the average wage doubled in the twenty years between 1953 and 1973.
It stagnated for a while in the 1970s but then grew steadily again in the 1980s, the 1990s and into the early years of the twenty-first century. Although long-term growth gets less media attention than does the current inflation or unemployment rate, it is the predominant determinant of living standards and the material constraints facing a society from decade to decade and generation to generation.
Business cycles
The economy tends to move in a series of ups and downs, called business cycles, rather than in a steady pattern. The 1930s saw the greatest world-wide economic depression in the twentieth century, with nearly one-fifth of the UK labour force unemployed for an extended period. In contrast, the twenty-five years following the Second World War were a period of sustained economic growth, with only minor interruptions caused by modest recessions. Then the business cycle returned in more serious form. There have been three major recessions in the United Kingdom during the last three decades (1973 – 5, 1979 – 81, and 1990 – 92), and most other major countries have experienced a similar pattern. Now, an understanding of business cycles is important for the owners and managers of firms. During recessions many businesses go bust, while profits fall for the survivors. In contrast, during a boom, demand for most products rise, profits rise, and most businesses find it easy to expand. Understanding the business cycle is, thus, important for successful businesses. Expanding capacity during the onset of a recession could be a recipe for disaster, while having too little capacity during a boom maybe a lost opportunity. Most importantly, although business cycles are beyond the control of individual firms, firms do need to understand that the economy moves in cycles. The government sometimes claim that their policies will bring stable growth and the end to cycles, but business cycles have been around for a long time, and they are likely to be with us for much longer yet.
Interest rates
Monetary policy involves changing interest rates, or the money supply, in order to influence the economy. High interest rates are a symptom of a tight monetary policy. When interest rates are high firms find it more costly to borrow, and this makes them more reluctant to invest in expanding their business. Individuals with mortgages or bank loans are also hit by high interest rates since it costs more to make their loan repayments. Hence high interest rates tend to reduce demand in the economy, firms invest less, and those with mortgages have less to spend. Low interest rates tend to stimulate demand. Another important channel of monetary policy is via the exchange rate, at least for countries whose exchange rates are flexible. Exchange rate changes can affect the relative prices, and thereby the competitiveness, of domestic and foreign producers. A significant appreciation of the domestic makes domestic goods expensive relative to foreign goods. This may lead to a shift of demand away from domestic goods towards foreign goods as we shall see later. Such shifts have an important influence on domestic economic activity.
Value added as output
The reason why getting a total for the nation’s output is not quite so straightforward as it may seem at first sight is that one firm’s output may be another firm’s input. For example a maker of clothing buys cloth from a textile manufacturer and buttons, zips, thread, pins, hangers, etc., from a range of other producers. Most modern manufactured products have many ready-made inputs. A car or aircraft manufacturer, for example, has hundreds of component suppliers. Production tends to occur in stages: some firms produce outputs that are used as inputs by other firms, and these other firms in turn produce outputs that are used as inputs by yet other firms. If we merely added up the market values of all outputs of all firms, we would obtain a total that was greatly in excess of the value of the economy’s actual output. The error that would arise in estimating the nation’s output by adding all sales of all firms is called double counting. Multiple counting would be a better term, since, if we added up the values of all sales, the same output would be counted every time it was sold from one firm to another. The problem of double counting is solved by distinguishing between two types of output. Intermediate goods and services are the outputs of some firms that are in turn inputs for other firms. Final goods and services are goods that are not used as inputs by other firms in the period of time under consideration. The term final demand refers to the purchase of final goods and services for consumption, for investment (including inventory accumulation), for use by governments, and for export. It does not include goods and services that are purchased by firms and used as inputs for producing other goods and services. In addition, if the sales of firms could be readily separated into sales for final use and sales for further processing by other firms, measuring total output would still be straightforward.
Total output would equal the value of all final goods and services produced by firms, excluding all intermediate goods and services. However, when a steel maker sells steel to Ford UK it does not care, and usually does not know, whether the steel is for final use (say, construction of a new warehouse) or for use as an intermediate good in the production of cars. To avoid double counting, statisticians use the important concept of value added. Each firm’s value added is the value of its output minus the value of the inputs that it purchases from other firms (which were in turn the outputs of those other firms). Thus, steel mill’s value added is the value of its output minus the value of the ore that it buys from the mining company, the value of the electricity and fuel oil that it uses, and the values of all other inputs that it buys from other firms. The total value of a firm’s output is the gross value of its output. The firm’s value added is the net value of its output. It is the figure from this that gives the firm’s contribution to the nation’s total output. It is what its own efforts add to the value of what it takes in as inputs.
Investment spending
This is defined as spending on the production of goods not for present consumption but rather for future use. The goods that are created by this spending are called investment (or capital) goods. Investment spending can be divided into three categories: changes in inventories, fixed capital formation, and the net acquisition of valuables.
Almost all firms hold stocks of their inputs and their own outputs. These stocks are known as inventories. Inventories of inputs and unfinished materials allow firms to maintain a steady stream of production in spite of short-term fluctuations in the deliveries of inputs bought from other firms. Inventories of outputs allow firms to meet orders in spite of temporary fluctuations in the rate of output or sales. Modern just in time methods of production pioneered by the Japanese aim to reduce inventories held by manufacturing plants to nearly zero by delivering inputs just as they are needed. Most of the economy, however, does not achieve this level of efficiency and never will. In addition an accumulation of stocks and unfinished goods in the production process counts as current investment because it represents goods produced (even if only half-finished) but not used for current consumption. A drawing down of inventories, also called de-stocking, counts as negative investment because it represents a reduction in the stocks of finished goods (produced in the current period) that are available for future use. Inventories are valued at what they will be worth on the market, rather than at what they have cost the firm so far. This is because the expenditure-based measure of GDP includes the value of what final spending on these goods would be if they were sold, even though they have not been sold yet.
All production uses capital goods. These are manufactured aids to production, such as machines, computers, and factory buildings. Creating new capital goods is an act of investment and is called fixed investment or fixed capital formation. The economy’s total quantity of capital goods is called the capital stock. Much of the capital stock is in the form of equipment or buildings used by firms or government agencies in the production of goods and services. This includes not just factories and machines, but also hospitals, schools, and offices. A house or a flat is also a durable asset that yields its utility (housing services) over a long period of time. This meets the definition of fixed capital formation, so housing construction is counted as investment spending rather than as consumption spending. When a family purchases a house from a builder or another owner, the ownership of an already produced asset is transferred, and that transaction is not a part of current GDP.
Some productive activity creates goods that are neither consumed nor used in the production process. Rather, they are held for their intrinsic beauty or for their expected appreciation in value. Examples are jewellery and works of art. Such works are known as valuables. Acquisitions less disposals of valuables are treated as investments in the national accounts.
Technological change
From time immemorial people have observed that technological change destroys particular jobs and have worried that it will destroy jobs in general. Two points are important in assessing this issue in relation to manufacturing. Firstly, technological change does destroy particular jobs. When water wheels were used to automate the fuelling of cloth in twelfth century Europe, there were riots and protests among the fullers who lost their jobs. A century ago, half of the labour force in North America and Europe was required to produce enough food to feed the population. (The figure was a little lower in the UK because British-manufactured goods were exported in return for imported foodstuffs). Today less than 3 percent of the labour force is needed in the high-income countries to feed all their citizens. In other words, out of every 100 jobs that existed in 1900, 50 were in agriculture, and 47 of those jobs have been destroyed by technological progress over the course of the last century. The second point is that new technologies create new jobs just as they destroy old ones. The displaced agricultural workers did not did not join the ranks of the permanently unemployed, although some of the older ones may have done, their children did not. Instead they, and their children, took jobs in manufacturing and services industries and helped to produce the mass of new goods and services that have raised living standards over the century, such as cars, refrigerators, computers, foreign travel, and so on over a vast list of new things. Technological change raises living standards by destroying jobs in existing lines of production and freeing labour to produce new commodities as well as more of some existing commodities. Modern technologies tend to be knowledge intensive and also the globalizing of world markets has lead to unskilled workers in advanced countries having to compete with unskilled workers everywhere in the world. Both of these factors are decreasing the relative demand for unskilled workers in developed countries.
The role of the Monetary Policy Committee
The Monetary Policy Committee (MPC) is made up of nine members. Five of these are senior Bank of England officials and four are outsiders appointed by the Chancellor of the Exchequer. The Governor of the Bank of England chairs the committee. The outside members are each appointed for a three-year period, while the term of the Bank insiders depends upon the length of their Bank contract. The MPC meets formally to set interest rates once every month, with announcements coming at noon on the first Thursday after the first Monday of each month. Decisions are made by a simple majority vote, with the Governor having a casting vote in the event of a tie. Prior to making this decision, MPC members have three days of meetings to evaluate the latest data on the state of the economy and debate among themselves the appropriate course of action. A record of the debate is published two weeks later in the form of the minutes of the meeting. Four times a year the Bank also publishes its inflation Report, which gives an in-depth assessment of the state of the economy. It contains the Bank’s forecast of inflation and GDP growth over the succeeding two-year period. Members of the MPC are also summoned from time to time by the Treasury Select Committee of the House of Commons to answer questions about how and why they reached the decisions they did on monetary policy in the past.
The government sets the target for inflation that the MPC is meant to achieve. The target set originally in 1997 was to keep inflation at 2.5 percent using the RPIX as the measure of inflation targeted, and this remained the goal until 2003. RPIX is constructed by removing mortgage interest payments from the standard RPI. The logic of using this measure was that, if inflation were expected to rise and the MPC tightened monetary policy in order to control it, this rise in interest rates would itself raise RPI, but not RPIX. Because it is impossible to hit an inflation target exactly, the MPC was given a band of plus or minus 1 percent. If RPIX inflation turns out at more than 3.5 percent or less than 1.5 percent, the MPC has to write an open letter to the Chancellor of the Exchequer explaining why this deviation had happened and setting out what it intended to do about it. The MPC has been given instrument independence, in that is can set interest rates at whatever level it thinks appropriate, but it does not have goal independence, as the government sets the inflation target. Choosing an interest rate to achieve an inflation target is not a simple matter. It requires a detailed quantitative understanding of the transmission mechanism in the economy. Because of time lags, the full effect of any policy has t be forward looking. In effect, policy-makers are targeting an inflation forecast rather than current inflation, because there is nothing they can do about inflation already reported, but they can take actions that will influence inflation in the future.
Changes in exchange rates
Exchange rates are affected by changes in the demand or supply in the foreign exchange market. Anything that shifts the demand curve for pounds to the right or the supply curve of pounds to the left leads to an appreciation of the pound. Anything that shifts the demand curve for pounds to the left or the supply curve of pounds to the right leads to a depreciation of the pound.
An increase in the demand for pounds or a decrease in the supply will cause the pound to appreciate; a decrease in the demand or an increase in supply will cause it to depreciate.
Suppose that the sterling price of UK-produced telephone equipment rises. The effect on the demand for pounds depends on the price elasticity of foreign demand for the UK products. If the demand is inelastic (say, because the United Kingdom is uniquely able to supply the product for which there are no close substitutes), then more will be spent; the demand for pounds to pay the bigger bill will shift the demand curve to the right, and the pound will appreciate. This is shown in the diagram previously. If the demand is elastic, perhaps because other countries supply the same product to competitive world markets, the total amount spent will decrease and thus fewer pounds will be demanded; that is, the demand curve for pounds will shift to the left, and the pound will depreciate. This is also shown in the diagram previously.
Suppose that the dollar price of US-produced videos increases sharply. Suppose also that UK consumers have an elastic demand for US videos because they can easily switch to UK substitutes. In this case they will spend fewer dollars on US videos than they did before. Hence they will supply fewer pounds to the foreign exchange market. The supply curve of pounds will shift to the left, and the pound will appreciate. If the demand for US videos is inelastic, spending on them will rise and the supply of pounds will shift to the right, leading to a depreciation of the pound.
Tags: average wage, business cycle, business cycles, economic depression, sustained economic growth, unemployment rate
