Q&A: Will the UK economy’s PPF shift inwards because of the recession?

Will the UK economy’s PPF shift inwards because of the recession?

This is an interesting question and hints that a deep recession that lasts longer than we expect can have a damaging effect on the UK economy’s supply-side performance and productive potential.

The conventional interpretation of a PPF diagram is that a cyclical recession leads to a reduction in the usage (utilisation) of existing resources of land, labour and capital. In other words we see a rise in unemployment and an increase in the amount of spare capacity as measured by the output gap.

This could be shown by a movement from a position close to the frontier of the PPF to a new point further inside the curve.

Notice how in the chart below, the OECD is forecasting that the British economy will be left with a sizeable negative output gap.

A more pessimistic view would be that there will be a negative effect on the real supply-side potential of the UK economy.

Business failures: The rate of business insolvencies is accelerating and capital investment spending is falling. In the last three months of 2008 there were 2,428 corporate insolvencies such as administrations and receiverships. That was a 220% rise on the same period the year before

With credit remaining hard to get, the resources freed up through businesses cutting back or closing down may be difficult to redeploy.

Unemployment is rising quickly and it often takes time for people to be re-employed in alternative jobs - much of the current unemployment is cyclical - but it could easily become structural and long term in nature. Indeed people who remain out of work for lengthy periods can leave the active labour market altogether.

In these circumstances the productive potential of the economy can contract and this has important implications for the likely trend rate of growth and also inflation risks in the medium term.