Unit 5 Macroeconomic policy: Inflation and unemployment
5.15 Application: Policy responses to supply shocks—case study of the UK 1950–2023
Follow the steps in Figure 5.23 to learn about the evolution of inflation and unemployment in the UK, and how policymakers responded to supply and demand shocks over the period 1950–2023. The ‘Supplementary figures’ section contains additional charts, which are also linked to in Figure 5.23, to illustrate other macroeconomic variables in the UK over this period.
Figure 5.23 Inflation and unemployment in the UK (1950–2023).
Inflation and unemployment in the UK (1950–2023)
Over the period 1953–2023, the UK moved from low inflation to sharp rises in the 1970s, reverting to fairly low and stable inflation, at least until 2022.
The chart also shows the gap between unemployment and the inflation-stabilizing rate, the NAIRU. While the Phillips curve would suggest that inflation should be negatively correlated with this gap, this relationship is often obscured in the data by supply shocks, shifts in policy, and shifts in inflation expectations.
By examining sub-periods, we can, however, relate the data to our models, and we can trace out the contrast between supply and demand shocks.
Note: According to the Phillips curve model, when the series for the unemployment rate minus the NAIRU is positive, inflation should be falling and vice versa.
Inflation and unemployment in the UK (1953–1967)
In this period, the UK had a fixed exchange rate, with fairly stable and low inflation. There was some evidence of rises in inflation when unemployment fell below the NAIRU.
Inflation and unemployment in the UK (1967–1980)
The UK progressively moved towards a flexible exchange rate, with regular depreciations (Figure 5.24). Monetary policy was directly controlled by the UK government, with no clear target inflation rate.
Sustained real rises in oil prices in the 1970s (Figure 5.25) acted as a negative supply shock, depressing real wage growth, and pushing up the inflation rate. But there was no attempt to offset this with tighter monetary policy: real interest rates were often negative (Figure 5.26), and unemployment actually fell below the NAIRU (which was itself increasing) (Figure 5.27).
As a result, the Phillips curve shifted up significantly as inflation expectations adjusted.
Inflation and unemployment in the UK (1980–1984)
During this period (discussed earlier in Figure 5.12), there was a sharp fiscal and monetary contraction, with real interest rates strongly positive for a sustained period (Figure 5.28), accompanied by a significant real exchange rate appreciation (Figure 5.29). This caused a significant recession with a large increase in unemployment above the NAIRU (Figure 5.30).
As a result, there were significant falls in inflation (with falling import prices making a big difference), but with very large costs to the economy, since inflation expectations had become embedded. As inflation fell, the Phillips curve progressively shifted back downwards.
Inflation and unemployment in the UK (1997–2020)
The Bank of England was given independent control of monetary policy, and followed an inflation targeting regime with a target of 2%.
Actual inflation mostly stayed close to target, with increasing evidence of anchoring of expectations.
Monetary policy during the global financial crisis
The Bank of England judged that the global financial crisis of 2007–2009 was a demand shock. It rapidly relaxed monetary policy, cutting nominal interest rates close to zero, so real rates were negative (Figure 5.31), with a sharp depreciation (Figure 5.32). This helped stabilize the economy, and limit the impact on unemployment, but at the cost of a temporary rise in inflation. However, inflation reverted to target fairly quickly.
Inflation and unemployment in the UK (2021–2023)
The Russian invasion of Ukraine caused a temporary shortage of natural gas in Europe. The resulting large increases in the price of gas (Figure 5.33), petrol, and electricity caused a sharp increase in inflation, and a significant cut in real wages as discussed in Section 4.11. As such, this was the first major negative supply shock since the 1970s, and the first real test of the inflation targeting regime. The Bank of England responded by raising nominal interest rates, but by less than the increase in inflation, so real interest rates initially fell (Figure 5.34). Many commentators felt that this response was inadequate, and risked inflation expectations shifting upwards again. But the Bank of England appears to have been relying on several factors that made this supply shock different from the 1970s:
• The significant cuts in real incomes were expected to weaken aggregate demand, even without a monetary tightening.
• While the rises in real oil prices in the 1970s were sustained, it was expected that the rises in gas prices in 2020 would rapidly unwind, since there was no evidence of a sustained shortage. As discussed in Section 4.11, the negative terms-of-trade shock was reversed. Gas prices did indeed fall back rapidly (Figure 5.33), helping to bring inflation back down.
• Evidence from financial markets showed that longer-term inflation expectations had not significantly shifted upwards (Figure 5.35).
By the end of 2023, the Bank of England appeared confident that inflation would return close to target. As inflation fell, real interest rates progressively rose (Figure 5.34).
Exercise 5.12 The UK’s policy responses (1950–2023)
Using the models discussed in this unit and the information in Figure 5.23, draw appropriate diagrams to explain the macroeconomic changes in the UK over the following periods:
- 1967–1980: flexible exchange rate with no clear inflation target
- 1980–1984: fiscal and monetary contraction
- 1997–2007: Bank of England given control over monetary policy
- 2007–2009: global financial crisis
- 2020–2023: COVID-19 pandemic and the Russia–Ukraine war
Supplementary figures Figures 5.24–5.35
This box contains Figures 5.24 to 5.35, which accompany Figure 5.23.
Figure 5.24 The GBP/USD exchange rate (normalized to equal 1 in 1953).
Figure 5.25 Real oil prices spiked in the 1970s.
Figure 5.26 1967–1980: Real interest rates (the difference between the Bank of England policy rate and the consumer price index) were mostly negative.
Figure 5.27 1967–1980: Unemployment fell below the NAIRU.
Figure 5.28 1977–1984: Real interest rates (the difference between the Bank of England policy rate and the consumer price index) were positive for a sustained period.
Figure 5.29 1977–1980: The real exchange rate appreciated significantly.
Figure 5.30 1980–1984: A significant increase in unemployment above the NAIRU.
Figure 5.31 1991–2019: Real interest rates (the difference between the Bank of England policy rate and the consumer price index) changed from positive to negative due to the global financial crisis.
Figure 5.32 2007–2008: A sharp depreciation in the exchange rate.
Figure 5.33 2021–2023: Gas prices increase due to the Russia–Ukraine war.
Wholesale market indicators, Ofgem.
Figure 5.34 2020–2023: Real interest rates (the difference between the Bank of England policy rate and the consumer price index) fell.
Figure 5.35 2022: Inflation expectations did not significantly shift upwards.