Economics Q&A: Will the Government spending cuts affect inflation?

In early July 2010 Chancellor George Osborne announced a tough government spending review designed to cut the size of the UK’s structural budget deficit and bring down managed state sector spending as a share of GDP. The UK is not alone in introducing fiscal austerity measures and they have prompted fierce debate not least among economists about the likely impact on economic performance. The spending squeeze brings to an end more than a decade of strong real terms increases in state spending.

This question is really about causation and in this case we are asked to think about how the steep planned cuts in government spending may affect the annual rate of consumer price inflation in the next couple of years.

The obvious starting point is to consider the impact on aggregate demand (C+I+G+X-M).

Government spending on goods and services is a sizeable percentage of total demand and real terms cuts in public sector expenditure will have a direct negative effect on the circular flow of income and spending. Cuts in G will also have negative multiplier effects leading to a larger final decrease in real GDP. Many private sector businesses supply goods and services to the public sector such as the NHS, schools and local authorities.

The independent Office for Budget Responsibility estimates that 330,000 public sector workers in the UK will lose their jobs over the next four year and there will be thousands more in supply-chain businesses.

In the absence of a compensating increase in private sector demand (for example consumer spending or exports of goods and services), a fall in AD from lower G will have a direct effect on the output gap. Actual GDP in the UK is already well below potential GDP and the fiscal squeeze will mean that demand-pull inflationary pressures will remain almost non-existent.

A second effect of government cut-backs might be seen in the rate of wage inflation. Many government departments will be scaling back on jobs and there will be increased pressure on workers in the public sector to agree to wage freezes or pay rises below the rate of inflation. This will lead to a reduction in the risks of cost-push inflation.

Govt spending cuts might also have an effect on the UK exchange rate for example against the Euro.

(i) A fiscal contraction makes it more likely that policy interest rates set by the Bank of England will stay low as we head into 2011. Ultra low interest rates might be a factor causing the UK currency to weaken in the foreign exchange markets

But

(ii) Greater credibility for the UK government in the bond markets may drive sterling higher if the UK is seen as having an appropriate policy for debt reduction.

The government has announced £81bn of planned spending cuts over the next few years. Assuming that these cuts are actually carried through (this is clearly open to doubt) the biggest risk seems to me to be that deep cuts in spending will bring about a double dip recession - driving UK inflation lower because of falling demand and extra spare capacity. There are good grounds for thinking that growth rates in the UK economy will be slower than in previous recoveries and the fiscal contraction will be a key factor behind this. The Office for Budget Responsibility has a GDP growth forecast of just 2.1% for 2011 whilst the Paris-based Organisation for Economic Co-operation and Development believes the UK economy will grow by just 1.7%.

As with most questions in macroeconomics, there are so many other factors that are unlikely to remain constant over the same period! We have seen consumer price inflation well above the 2% target in much of the past two years but the causes have in the main come from external events in the world economy - notably the steep increases in the prices of foodstuffs, oil and gas and many other primary commodities.

Much of the inflation that we experience in the UK is determined by global economic forces beyond the control of the government and the Bank of England.