Normative and Positive Economics

 A positive economic statement is a statement that can be verified true or false.

A normative economic statement is an opinion. It is a view that others may disagree with.

Postive economics

• In the UK, Dec 2017 CPI inflation is 3.0%
• In the UK the rate of unemployment has increased by 50% in the past three years.

Normative Economics

This is the expression of an opinion.

• The MPC should not be concerned about the rise in CPI inflation because it is due to temporary factors.
• Unemployment is more important than inflation in the current economic situation
• The MPC should increase interest rates to deal with the rise in inflation.
• The government should try to reduce inequality
• Privatisation leads to a more efficient allocation of resources

Both the above statements are value judgements, you can’t prove it right or wrong by merely looking at statistics. Some economists believe the first statement, others believe the second statement is more valid.

Economics is part science part art. The science is the positive economics – finding data such as inflation and unemployment statistics. However, with this data, you can make very different judgements.

The rise in inflation is a good example of how economists can reach very different conclusions from the same data.

Other examples

• UK public sector debt is 60% of GDP. – positive
• An increase in GDP per capita leads to an increase in living standards – normative. Higher GDP doesn’t necessarily lead to higher living standards.
• Mixed economies are the best form of economic system. –   normative  (even though the vast majority of economists would agree.)

On a recent visit to New York, my friends took me to a popular part of Queens to an Indian restaurant. Because it is a popular area it was very difficult to find a car parking space. We ended up driving round in circles for 15 minutes before a space finally became available. When we finally parked, I was surprised to see there was no charge for parking in this busy area.

Diagram showing Excess Demand when Price is Zero

If price is £0 demand (Q2) is greater than supply (Q1)

I suggested to my friend it would be more socially efficient if there was a charge for parking.
Because it was free to park, demand was greater than supply. This shortage caused:

• Time wasted
• Stress of looking for car parking space
• Congestion on the roads as many drivers are just driving around looking for a parking space.
• More pollution as drivers create more fumes driving around looking for a space.
• It can put people off visiting restaurants because a perceived lack of parking can become a disincentive.

Advantages of charging for parking

• It would encourage people to consider other forms of transport for getting into the area.
• People might use public transport or even cycle.
• Lower emissions from cars driving into centre
• The money raised from car parking charges could be used to offset other taxes or spend on improving public transport/bicycle lanes e.t.c.
• People might walk or cycle a bit more. This would be one way to deal with obesity issues in the West.

Yet, the response of my local New Yorker friends was that ‘they didn’t want to pay another tax’.  They expected free parking and think of free parking as an entitlement. They didn’t really like driving around looking for a car parking space, but they definitely don’t want to pay.

Equity issues

Some might say car parking charges would favour rich people who would be able to afford to park in the city centre. Certainly, rich people wouldn’t be discouraged by a small parking charge. But, concerns about equality should not be dealt with through the price of car parking. We don’t reduce tax on cigarettes just because cigarette tax is highly regressive.

Amsterdam pedestrianised many areas of their city centre and made car parking very expensive. As a result, 40% of people cycle within Amsterdam, and they seem to enjoy it. (cycling Holland)

In a way car parking charges can be an effective ‘mini congestion charge’ By raising the cost of driving into city centres it makes people pay the full social cost and not just the private cost.

The high cost of free parking

“Who pays for free parking? Everyone but the motorist.”

– Professor Shoup

Professor Donald Shoup wrote a book The High Cost of Free Parking which examines the social cost of free parking in the US.

He noted that land reserved for car parking space has a very high value, yet we give it away for free. He measures the value of a Los Angeles parking space at over $31,000. As Tyler Cowen notes in a review of Professor Shoup’s work. “If we don’t give away cars, why give away parking spaces?”

Professor Shoup estimated that the value of the free-parking subsidy to cars was at least $127 billion in 2002

Trade off between unemployment and inflation

A look at the extent to which policymakers face a trade-off between unemployment and inflation. The Phillips curve suggests there is a trade-off between inflation and unemployment, at least in the short term. Other economists argue the trade-off between inflation and unemployment is weak.

Why is there a trade-off between Unemployment and Inflation?

• If the economy experiences a rise in AD, it will cause increased output.
• As the economy comes closer to full employment, we also experience a rise in inflation.
• However, with the increase in real GDP, firms take on more workers leading to a decline in unemployment ( a fall in demand deficient unemployment)
• Thus with faster economic growth in the short-term, we experience higher inflation and lower unemployment.

Increase in AD causing inflation

This Keynesian view of the AS curve suggests there can be a trade off between inflation and demand deficient unemployment.

If we get a rise in AD from AD1 to AD2 – we see a rise in real GDP. This rise in real output creates jobs and a fall in unemployment. However, the rise in AD also causes a rise in the price level from P1 to P2. (inflation)

 

Phillips Curve Showing Trade-off between unemployment and inflation

In this Phillips curve, the increase in AD has caused the economy to shift from point A to point B. Unemployment has fallen, but a trade-off of higher inflation.

If an economy experienced inflation, then the Central Bank could raise interest rates. Higher interest rates will reduce consumer spending and investment leading to lower aggregate demand. This fall in aggregate demand will lead to lower inflation. However, if there is a decline in Real GDP, firms will employ fewer workers leading to a rise in unemployment.

Empirical evidence behind trade-off

The Phillips Curve is based on the findings of A.W. Phillips in The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861–1957. Note: originally Phillips looked at the link between unemployment and nominal wages

This graph shows unemployment and inflation rate for the US economy.

There are occasions when you can see a trade-off.

• For example, between 1979 and 1983, we see inflation (CPI) fall from 15% to 2.5%. During this period, we see a rise in unemployment from 5% to 11%.
• In the late 1980s, inflation falls from 6.5% to 2.8%. But unemployment rises from 5% to 8%
• In 2008, we saw inflation fall from 5% to 2%. During this time, we see a sharp rise in unemployment from 5% to over 10%.

This suggests there can be a trade-off between unemployment and inflation.

However, equally you can look at other periods, and the trade-off is harder to see.

UK Evidence – Unemployment v Inflation

% annual change in inflation and unemployment.

Monetarist View

The Phillips curve is criticised by the Monetarist view. Monetarists argue that increasing aggregate demand will only cause a temporary fall in unemployment. In the long run, higher AD only causes inflation and no increase in real GDP in the long term.

Monetarists argue LRAS is inelastic and therefore Phillips Curve looks like this:

Monetarist Phillips Curve Diagram

Rational expectation monetarists believe there is no trade-off even in the short-term. They believe if the government or Central Bank increased the money supply, people would automatically expect inflation, so there would be no improvement in real GDP.

Falling Inflation and Falling Unemployment

In some periods, we have seen both falling unemployment and falling inflation. For example, in the 1990s, unemployment fell, but inflation stayed low. This suggests that it is possible to reduce unemployment without causing inflation.

However, you could argue there is still a potential trade-off except the Phillips curve has shifted to the left, because there is now a better trade-off.

It also depends on the role of Monetary policy. If monetary policy is done well, you can avoid some of the boom and bust economic cycles we experienced before, and enable sustainable low inflationary growth which helps reduce unemployment.

Rising Inflation and Rising Unemployment

It is also possible to have a rise in both inflation and unemployment. If there was a rise in cost-push inflation, the aggregate supply curve would shift to the left; there would be a fall in economic activity and higher prices. For example, during an oil price shock, it is possible to have a rise in inflation (cost-push) and rise in unemployment due to lower growth. However, there is still a trade-off. If the Central Bank sought to reduce the cost-push inflation through higher interest rates, they could. However, it would lead to an even bigger rise in unemployment.

In 1970s, a period of cost-push inflation led to breakdown of Phillips Curve – or at least gave a worse trade-off.

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