Free Lunch (26 page)

Floating currencies:
The system that has existed since the early 1970s, in which currencies are not fixed in value against others. The dollar, the yen, the euro and the pound float freely. Not all currencies are floating. Some are tied to the dollar while European currencies were linked in the exchange rate mechanism of the European Monetary System prior to the adoption of the euro.

Full employment:
In practice, an unemployment rate of 2 or 3 percent – when everybody who could reasonably be in work is in employment. Why not zero? Because there will always be some people moving between jobs (frictional unemployment) and temporarily unemployed because of the weather or the state of the tourist trade (seasonal unemployment). Employment may still rise in a situation of full employment if more people can be lured into the workforce, for example married women or older people.

Game theory:
The modelling of economic decision-making by means of games or strategies. Outcomes for firms and individuals depend not only on their decisions and strategies but also on what others do. The pioneers of game theory were John Von Neumann and Oskar Morgenstern, in their 1944
Theory of Games and Economic Behaviour
. They gave us the idea of the ‘zero sum game’ in which one player’s gain is another’s loss. John Nash was responsible for demonstrating that the outcome of a game, in other words of any economic decision, could be a ‘win–win’ one.

Gini coefficient:
The standard measure of inequality within or between countries. It varies between 0 and 1. A Gini coefficient of 0 would imply a perfectly equal distribution of income, with everybody getting the same, while a coefficient of 1 would mean that one person would receive everything.

Gold standard:
The international monetary system in which all currencies were fully backed by and convertible into gold.

Golden rule:
A self-imposed fiscal rule that says the government should borrow only for investment, not current spending.

Government bonds:
Interest-bearing bonds issued by the government to borrow from the financial markets or the public. Bonds are of short- (up to five years), medium-, or long-term duration – up to thirty years, sometimes longer. The yield, or interest, on government bonds is an important determinant of interest rates elsewhere in the economy. In Britain government bonds are called gilts (gilt-edged securities).

Gross domestic product:
GDP, the most common measure of overall activity in the economy within a given period. GDP can be calculated three ways – it is the total of spending (GDP = C + I + G + X - M), the sum of production, and the total of all incomes received. All three should produce roughly the same answer. GDP at market prices includes taxation, while GDP adjusted for taxes and subsidies is GDP at factor cost. Gross national product is roughly similar to GDP, but also includes net property income from abroad. In some countries the GDP/GNP difference is quite significant, but not in the case of Britain.

Group of Seven:
A grouping of the world’s most powerful countries, the G7 started life as the Group of Five (America, Japan, Britain, Germany and France) in the mid-1970s, with Canada and Italy added soon afterwards. The G7, which now includes Russia at some of its meetings, when it becomes the G8, holds annual summits and more frequent meetings between its finance ministers and central bankers.

Human capital:
Without a skilled and educated workforce, investment in the latest machinery will be futile. Investing in human capital, in education and training, can be as important as investing in equipment, although the returns may take longer to show through.

Hyperinflation:
Runaway inflation, when the value of money falls at an alarming rate. Countries with inflation rates of 50 percent or more
per month
are experiencing hyperinflation.

Indifference curve:
A representation of a consumer’s preferences between apples and pears, or income and leisure, or anything else. A consumer may be indifferent between five apples and five pears, or three apples and eight pears, and so on. Indifference curves can never cross.

Indirect taxation:
Mainly taxes on spending, such as VAT and excise duties.

Inflation:
A general increase in the price level, and one of the main targets for modern-day economic policy. The UK inflation target of 2.5 percent sounds low but it means prices would double in just over twenty-five years. A 4 percent target would mean a doubling of prices every fifteen years. Economists regard a small amount of inflation as desirable, not least to avoid the danger of deflation. Strictly speaking, inflation should be used only to measure a general increase in prices but people often refer to house price inflation or wage inflation. The main measure of inflation used in Britain is based on the retail prices index, although producer price inflation data (industry’s input and output costs) are also published. The most comprehensive inflation measure is derived from GDP data, the GDP deflator.

Infrastructure:
Roads, railways, telecommunications, hospitals, schools and other forms of public investment, these are usually but not necessarily built and maintained by government. An inadequate infrastructure has been blamed for undermining Britain’s economic performance.

Interest rate:
The cost of borrowing, or the price of money. The amount that has to be paid to a lender for foregoing the use of money now. The rate of interest, more importantly, is the main weapon of monetary policy. Raising interest rates – increasing the cost of borrowing – tightens policy, and vice versa.

J-curve:
A description of the likely balance of payments effects of currency devaluation. Initially the current account worsens, because imports have become more expensive. Only later is there an improvement as exports benefit from the devaluation.

Keynesian policies:
The use of a fiscal policy in an activist way to manage demand in the economy. A recession would be tackled with higher public spending and tax cuts, and the opposite policies would be adopted in a boom. The heyday of Keynesian policies was in the 1950s and 1960s.

Laffer curve:
A graphical demonstration of the fact that higher tax rates can result in lower tax revenues.

Liquidity trap:
The situation, defined by Keynes, in which monetary policy becomes ineffective because interest rates cannot fall low enough to stimulate economic activity. When there is deflation or falling prices, there is also likely to be a liquidity trap.

Marginal rate of tax:
The tax paid on an additional pound of income earned. A higher rate taxpayer in Britain pays a marginal tax rate of 40 percent. Marginal cost, marginal revenue and marginal utility are all key concepts in economics. Firms produce to the point where marginal cost equals marginal revenue. In each case ‘marginal’ refers to an additional unit.

Monetarism:
The belief that inflation is ‘always and everywhere’ a monetary phenomenon and that inflation results from increases in the money supply. While agreeing on this general position, monetarists argue among themselves about the choice of target measures for the money supply and about how best to control them. The modern heyday for monetarism was in the 1980s.

Monetary policy:
Decisions that affect the cost and availability of money. Monetary policy, mainly exercised through interest rate changes, is regarded as the most effective tool for short-term economic management.

Monetary policy committee:
A committee within the Bank of England of nine men and women that meets each month to agree the level of interest rates. The MPC, which is chaired by the governor of the Bank, came into being in 1997 when the Bank was given ‘operational independence’, control over interest rates. It is charged with achieving an inflation target set by the government, currently 2.5 percent. Five members of the committee are Bank ‘insiders’, including the governor and two deputies; four are outside appointments, made by the Chancellor of the Exchequer.

Money supply:
The stock of money is the amount of money in circulation; the money supply describes changes in that stock in a given period. Measures of the money stock (and money supply) range from the very narrow such as M0, mainly notes and coin, to the very broad, M5, which includes all forms of credit and deposits.

Monopoly:
Strictly speaking a situation in which there is only one firm in an industry. A monopsony refers to a single buyer for an industry’s products. In practice, monopoly situations develop when a firm establishes a dominant position within an industry. Oligopoly refers to dominance of an industry by a few large players, as is the case for Britain’s supermarkets and banks.

Multiplier:
Essential to Keynesian economics, the notion that an injection of spending has knock-on effects beyond the initial impact. An extra £5 billion of government spending will, in creating incomes for public sector workers and suppliers, create additional spending elsewhere in the economy. Keynesians have traditionally argued that these multiplier effects are large, while post-Keynesian economists say they will be neutralized by the fact that people will recognize that higher government spending will result either in future tax rises or inflation.

Natural rate of unemployment, Nairu:
The level of unemployment consistent with a stable rate of inflation. The Nairu, another way of describing the natural rate, is the non-accelerating inflation rate of unemployment. The idea, introduced by Milton Friedman, is that the natural rate is determined by supply-side factors, such as the skills of the workforce and how they are distributed around the country, together with factors such as the operation of the benefits system (over-generous benefits discourage the low-paid from taking jobs). Measures to expand the economy and reduce unemployment below the natural rate will result in inflation. Most economists accept the existence of a natural rate or Nairu, although they have found it difficult to estimate exactly where it is at any one time, making it an imprecise tool for policymakers.

Optimal currency area:
An area or group of countries in which it is appropriate to have a single currency, this concept has been much used in the debate over the euro.

Output gap:
A broad measure of spare capacity in the economy, the difference between actual GDP and its trend or long-run level. An economy which starts on trend, and has a trend rate of growth of 2.5 percent, would have a positive output gap (i.e. spare capacity) after two years of 1 percent growth, but a negative output gap – it would be operating above capacity – after two years of 4 percent growth. Again, it would be a more useful tool for policymakers if economists were better at estimating it.

Perfect competition:
The textbook model of a market, with many firms producing identical products and each having to accept the same market price for their product. Buyers have perfect information. For a time, some economists believed the Internet had characteristics of perfect competition.

Phillips curve:
The relationship between unemployment and wage inflation developed by A. W. ‘Bill’ Phillips. The higher the level of unemployment, the lower the rate of wage inflation. In the late 1960s Milton Friedman introduced a new version of the Phillips curve, adjusted for expectations about inflation.

Productivity:
An important determinant of prosperity. Labour productivity is output divided by the number of workers (or worker-hours) needed to produce it. The faster the rate of growth in productivity over time, the higher the trend rate of growth of GDP. Capital productivity is the same concept applied to investment. Total factor productivity is the combination of labour and capital productivity.

Quantity theory of money:
The formal basis of monetarism, the link between the money supply and inflation. MV = PT (or PY), where M is the money stock, V its velocity of circulation, P the price level, T the number of transactions (Y is real GDP). Changes in M, money, will mostly be reflected in changes in P, prices.