Quarterly Bulletin
Structural Aspects of the Economy Articles

The economic characteristics of immigrants and their impact on supply (638k)
(By Jumana Saleheen and Chris Shadforth of the Bank's External MPC Unit). Immigration to the United Kingdom has risen rapidly over the past decade, driven most recently by flows from the ten EU Accession countries. Monetary policy makers are interested in the impact of immigration on the macroeconomy and inflation. An increase in the number of immigrants, other things being equal, would raise the supply potential of the economy. But the extent to which potential supply increases will depend on the economic characteristics of immigrants. This article investigates the characteristics of immigrants, particularly new immigrants - those who have entered the United Kingdom in the past two years. It appears that new immigrants are more educated than both UK-born workers and previous immigrant waves, but are much more likely to be working in low-skilled occupations. The increasing share of new immigrants in low-skill, low-paid jobs seems to have led to the emergence of a gap between the wages of new immigrants and UK-born workers. The implications of these findings for overall productivity and the supply side of the economy are complex.

Measuring capital services in the United Kingdom.
(143k)
(by Nicholas Oulton of the Bank's Structural Economic Analysis Division). For many macroeconomic purposes, such as the study of productivity or the assessment of capacity utilisation, we need measures of the level and growth rate of the productive services that the capital stock is capable of providing. The official estimates of the capital stock produced by the Office for National Statistics aim to be measures of wealth, not capital services. So while they are appropriate for their intended purposes, such as balance sheet analysis, they may not be appropriate for productivity analysis or in measures of capacity utilisation. This article discusses the theory behind a different concept of capital, called here the volume index of capital services (VICS), and presents estimates of the VICS for the United Kingdom—based on both a five-asset breakdown and an eight-asset breakdown—for the period 1979-99. The eight-asset breakdown includes three information and communications technology (ICT) assets: computers, software and telecommunications equipment. The VICS measure has grown faster than the wealth measures, and the divergence is more apparent when ICT assets are included explicitly.

Capital flows and exchange rates (179k)
(by Andrew Bailey of the Bank's International Economic Anlaysis Division, and Stephen Millard and Simon Wells of the Bank's Monetary Instruments and Markets Division).This article focuses on the possible role of capital flows in explaining exchange rate movements. Some commentators have suggested that a substantial increase in capital flows into the United States could have accounted for the recent appreciation of the US dollar. This could imply that capital inflows have increased in response to a rise in the rate of return on capital, which in turn has reflected the structural increase in US productivity seen in recent years. We find evidence to suggest that this may explain part of the recent dollar appreciation, but unsurprisingly it does not provide a full explanation.

Can differences in industrial structure explain divergences in regional economic growth? (74k)
(By Beverley Morris of the Bank's Conjunctural Assessment and Projections Division). The Bank of England has a responsibility to monitor regional and sectoral information for the purposes of formulating monetary policy. Examining the differences in economic activity between the regions can improve understanding of the nature of economic cycles, and of the transmission of policy changes through the national economy.

During the early to mid-1990s, the pace of economic growth in the South was broadly comparable with that in the rest of the United Kingdom. During 1996–98, however, the pace of activity in the South strengthened considerably relative to the rest of the country. This article investigates one possible explanation for divergences in growth between the two regions—namely differences in the relative importance of the manufacturing and service sectors. The results suggest that such differences in industrial structure do not account for the majority of the regional divergences in growth. Rather, it appears that they are explained mostly by a pick-up in population growth and stronger service sector activity in the South relative to that in the rest of the country over the period.

Saving, wealth and consumption (98k)
(by Melissa Davey of the Bank's Structural Economic Analysis Division). Since the mid-1990s the UK household saving ratio has fallen substantially, recently reaching its lowest level since the late 1980s. A key influence has been the large increase in the value of wealth, driven by rises in both equity and house prices, which is likely to have reduced households' incentive to save.

This article discusses the various forms of household saving and their determinants, and discusses the interactions between saving, wealth and consumption.

The first section of this article shows that the fall in the saving ratio has been associated with rising borrowing, including mortgage equity withdrawal, which tends to be related to increases in housing wealth. The second section looks at capital gains and losses, and how these can be considered as part of wider income and hence affect the level of saving. The third section discusses how the sources and composition of wealth gains may affect the response of consumption and saving.

Mortgage equity withdrawal and consumption
(68k)
(by Melissa Davey of the Bank's Structural Economic Analysis Division). Mortgage equity withdrawal is borrowing that is secured on the housing stock but not invested in it, so it represents additional funds available for reinvestment or to finance consumption spending. Mortgage equity withdrawal was an important source of finance in the 1980s. But it fell back sharply in the 1990s, and remained negative for much of the decade. This article discusses the motivation for and the effects of mortgage equity withdrawal, using evidence from a recent consumer survey carried out for the Bank of England and the Council of Mortgage Lenders.

The first section outlines how the Bank calculates aggregate mortgage equity withdrawal, and explains the relationship between this aggregate measure and other macroeconomic variables. The second section outlines the results of a microeconomic study of the various ways in which households can withdraw equity. The third section reports the results of a recent MORI survey, which investigates how equity is withdrawn, what it is spent on and why this method of finance was used.

Age structure and the UK unemployment rate
(47k)
(by Richard Barwell, formerly of the Bank's Structural Economic Analysis Division). Most models of the labour market assume a short-run trade-off between unemployment and inflation; this assumption is at the heart of the Phillips curve relationship and the expectations-augmented models that followed it. So recent developments in the labour market have puzzled economists: in August 1999, for example, the number of people out of work and claiming benefit fell to a 19-year low and yet the RPIX inflation rate was at its lowest level for more than five years.

Part of the explanation of this puzzle may be that the natural or equilibrium rate of unemployment has fallen, enabling the actual unemployment rate to fall substantially without generating a pick-up in inflation. Explanations for the fall in the natural rate have tended to focus on supply-side factors, such as the decline in union bargaining power, reduced generosity of unemployment benefits and increased deregulation of the labour market. This paper examines another supply-side explanation, which has received less attention in the United Kingdom: that the natural rate has fallen partly because of changes in the composition of the labour force. Youths tend to have higher unemployment rates than adults, and presumably have higher natural unemployment rates as well. The proportion of youths in the labour force almost halved over the past decade, so we would expect the aggregate unemployment rate and the natural rate to have fallen as a result.

Most of the existing literature investigating the impact of demographic change on the unemployment rate has looked at the US labour market. Katz and Krueger (1999) find that changing age structure accounts for about half of the fall in US unemployment between 1979 and 1998; Shimer (1998) finds that the effect is even larger, at about 70%. This paper provides a comparable estimate of the fall in UK unemployment that can be accounted for by the decline in the youth share of the labour force.

The first section presents two key stylised facts, which together suggest that demographic change could play a significant role in explaining recent developments in the UK labour market. First, that the youth share of the labour force has fallen dramatically over the last decade, and second, that youths always have higher unemployment rates than adults; the latter is analysed in the second section. The third section explains the 'shift-share' methodology developed in the literature, and uses it to provide a range of estimates of the impact of demographic change in the labour force on the unemployment rate. The fourth section discusses two alternative approaches that control for changes in the labour force participation rates of each age group.

Quantitatively, demographic pressures do indeed appear to explain part of the change in actual unemployment. Although this change is sensitive to the precise measure used, particularly the assumption made about the base year, it appears that about 0.55 percentage points, or 10%, of the fall in the unemployment rate between 1984 and 1998 can be accounted for by changes in the composition of the labour force. There is no robust evidence, however, that youths became less likely to become unemployed, through generational crowding effects, as their share of the labour force declined.

However, demographic pressures were not the only forces that affected the composition of the labour force over the period; changes in the participation rates of different age groups will also affect the unemployment rate. Controlling for these, demographic change explains less of the change in the unemployment rate over the period. However, it appears that the shift in the composition of the population caused by the baby boom and bust still explains about 0.45 percentage points of the fall in the unemployment rate over the period.

Finally, on the basis of current projections, it appears that future shifts in the composition of the labour force will have little effect on the unemployment rate over the next decade.

The financing of small firms in the United Kingdom
(66k)
(by Melanie Lund and Jane Wright of the Bank's Domestic Finance Division). Economists have often argued that imperfections in the financing of small firms arise because of information asymmetries: the small business owner generally has much better information than the bank on his firm's performance. This is fundamentally different from the situation with large companies. This article examines the developments over the past decade in the financing of small businesses in the United Kingdom. It notes the sector's reduced dependence on external funds and increased use of a range of financing products. The article also assesses the current risks faced by the small firms sector and its providers of finance, suggesting that this sector is now more resilient to a downturn in the economy than in the early 1990s, thus reducing the likelihood of a recurrence of the high levels of business failures experienced in that recession.

The article looks at the economic theory on the provision of finance in the small firms sector, indicating how market failures in the financing of small firms could arise from information asymmetries, leading to problems of adverse selection and moral hazard. Empirical evidence provides little conclusive support for the existence of such imperfections, but the theory highlights banks' problems in undertaking risk assessment of these firms.

The article examines how the patterns of small firms financing have changed over the past decade, making it less likely that the high levels of business failures and bank losses experienced in the previous recession will recur. It was noted that small businesses are now more appropriately financed than in the early 1990s. They are more dependent on internal sources of finance - with many of the smallest businesses being net creditors to the banking sector - and businesses that do require external finance now use a wider range of finance products. Traditional bank finance does, however, remain the most important source of external finance for small businesses.

Market competition in the provision of finance to small firms was identified as a means of facilitating and maintaining the momentum for improvement. The providers of bank finance to small businesses operate in a concentrated industry, but the degree of competition in this market is increasing, because of technological changes and new entrants.

One area where improvement in the provision of finance is less evident is in the supply of risk capital for technology-based small firms. Problems appear to arise at the start-up stage, where supplies of 'seedcorn' and early-stage equity finance are limited. Many formal venture capital firms tend not to invest in small enough amounts for these companies, and the informal venture capital market (business angels) is still underdeveloped compared with that in the United States.

Inflation and growth in a service economy (99k)
(by DeAnne Julius, member of the Bank's Monetary Policy Committee and John Butler of the Bank's Conjunctural Assessment and Projections Division). This article sets out the initial findings of a project team set up by the Bank to examine the behaviour of the service sector, in the light of the increasingly important role that services play in the UK economy, and so in achieving the Government's inflation target.

The project has drawn on work by others, both from this country and abroad. It tries to reach comprehensive and aggregate conclusions where possible, while still recognising the critical diversity within the huge UK service sector. Through the Bank's network of regional Agents, the project team has also benefited from discussions with many service businesses. Their initial findings are primarily descriptive and backward-looking, typically covering the period 1970­97, or as much of it as the relevant data series allow. They quantify the growing role of services in the UK economy, and identify the key differences revealed by the data between the behaviour of services and the rest of the economy.

With the growing significance of the service sector in the UK economy, it becomes increasingly important to understand how the sector behaves, not least because of its potential impact on inflation, and in achieving the inflation target set by the Government. But less is still known about services than about the manufacturing sector. The initial findings of the Bank's project team, described in this article, give rise to a number of issues that might be followed up in further work, by either the Bank or others.

The cyclicality of mark-ups and profit margins: some evidence for manufacturing and services (183k)
(by Ian Small of the Bank’s Structural Economic Analysis Division). This article reviews how price-cost mark-ups and firm profit margins in UK manufacturing and services behave over the business cycle, to see whether they move pro-cyclically. Movements in mark-ups and margins are important because of their effect on prices: pro-cyclical changes might suggest that price pressures increase during recovery periods and decrease during recessions.

The article aims to extend the existing work by examining whether mark-ups and profit margins are pro-cyclical not only in manufacturing, but also in non-manufacturing industries, particularly retailing.

It looks at the cyclicality of mark-ups, using Haskel et al’s extension to Robert Hall’s method of estimating mark-ups. It then looks at the cyclicality of firm profit margins, using Machin and Van Reenen’s model of firm profitability, to see if profit margins are still pro-cyclical even after adjusting for other factors that vary with time. Using these two different approaches and datasets acts as a test on the reliability and robustness of the results.

The article presents evidence that both mark-ups and profit margins are pro-cyclical in services as well as in manufacturing. This suggests that price pressures may move in line with the business cycle, increasing during the recovery period and decreasing during recessions.

Are prices and wages sticky downwards? (80k)
(by Anthony Yates of the Bank’s Structural Economic Analysis Division). In this article, Anthony Yates examines the theoretical and empirical evidence for prices being sticky downwards - in other words, for the existence of downward nominal rigidities. This evidence has most commonly been cited in the context of wages - if downward nominal rigidities exist and prevent wages from adjusting fully to a shock to demand or supply, then such a shock may affect levels of employment.

The article reviews the theoretical and empirical evidence for the existence of downward nominal rigidities. It argues that, contrary to the reasoning implicit in studies by others, a concern about fairness is not sufficient to generate downward nominal rigidities in wages. Other assumptions are also needed: that there are union cartels; or that individuals/unions have no knowledge of outside wages; or that individuals/unions are highly averse to falling behind when wage contracts are staggered. A second possibility raised in the literature is that individuals might suffer from money-illusion. But they must also display loss aversion for this to be an explanation of downward nominal rigidities.

Three arguments are advanced to support the existence of downward nominal rigidities in product markets. Price cuts may confuse customers used to positive inflation (a form of money-illusion); may be interpreted as quality cuts (and buyers are subject to money-illusion); and may be inhibited by strategic behaviour between firm cartels.

Four types of empirical evidence are examined:

• the frequency of wage and price cuts, which is not particularly illuminating, since it is unknown how frequent wage and price cuts would be in a frictionless world running at a given inflation rate;
• the skewness of the distribution of wage and price changes, which should be negatively related to the mean if downward nominal rigidities were operating. This was generally found not to be the case for either wages or prices in the United Kingdom;
• survey evidence (in particular from the Bank) on how firms set prices, which shows that prices are downwardly rigid in response to some phenomena, but upwardly so in response to others; and
• evidence on the UK Phillips curve, which it has been argued is not significantly convex.

Much of the empirical evidence is only consistent with and not proof of downward nominal rigidities, and tests have not revealed the existence of downward nominal rigidities in countries or time periods in which prices were falling. Moreover, there are theoretical models that predict that at positive rates of inflation, we are more rather than less likely to detect empirical relationships that reveal an apparent downward nominal rigidity.

In short, the theoretical arguments for downward nominal rigidities are more complex than much of the literature would have us believe. The empirical evidence leaves the case for downward nominal rigidities at best unproven.