The UK economy will soon be completing the third year of recovery from the low point of the business cycle reached in the second quarter of 1992. Since that time output has risen by close to 8 per cent and now stands at 4 per cent above its previous peak. Over the recovery phase of the cycle, output in the onshore economy has grown at an average rate of 2.7 per cent per annum, with the annual rate of expansion accelerating to reach 3.7 per cent in the last quarter of 1994. This rate of growth is certainly in excess of that which the economy can sustain in the long term. Unsustainable growth eventually leads to inflationary pressure as firms, faced with strong product demand, push up their prices. Depending on the attitude of the monetary authorities, this leads either to a period of higher inflation or to tighter policy and higher interest rates to prevent inflation speeding up.

Output growth throughout the OECD has been rising this year, and several economies including the US, Canada and the UK look as if are reaching their cyclical peak. Other economies, such as France, Italy and Spain, are still operating below capacity, but have been growing rapidly enough to prevent output gaps widening. Output gaps in Europe appear to be small, and Barrell and Sefton (below) calculate they could be approaching zero. This upturn in activity has been unlike most in the post-Bretton Woods era, as inflation has not, until recently, begun to rise. Inflation in the US was, it appears, lower in 1994 than in the previous four years, despite a strong output recovery. The appreciation of the yen, and the subsequent recession have, of course, kept Japanese inflation low. However, exchange-rate movements are part of a process of ‘sharing’ world inflation, and over the past three years there has been little to share. For example, inflation in Europe has been lower than we anticipated 18 months ago, even though a slowdown in activity was already apparent then.

This note examines the role of macroeconomic models in the policy design process. It discusses some of the general issues that need to be addressed if macroeconomic models are to make an important contribution to the policy debate. More topically, it illustrates the role that can be played by using policy optimisation techniques on the National Institute UK model to examine some of the macroeconomic policy options currently facing policymakers.

As the UK economy recovers from the recent recession, there is again widespread concern at the re-emergence of the spectre of inflation. Recent increases in base rates were primarily aimed at reassuring markets that inflation will be controlled. It is therefore of use to be able to calculate whether or not inflationary pressures are liable to re-emerge in the near future. Our macroeconomic, model based, forecast on page 8 of this Review is one way that this could be done. This note investigates a number of other approaches.

Can unemployment be cured by flexible labour markets? This current nostrum had little to do with the maintenance of full employment, with little inflation, throughout the 1950s and 1960s. The secret of that success can be traced to the high level of investment, which stimulated both supply and demand in the economy, and enhanced the employability of labour. Downward pressures exerted on the cost of labour appear to have had some effect on unemployment in the 1980s, but are likely to run out of steam before it is reduced to a tolerable level. Attention now needs to be concentrated on enhancing the employability of labour. But whether this is attempted through tax incentives to investment or other means, its purpose will be liable to be thwarted unless accompanied by general restraint in the upward adjustment of real wages.