Are half a million hardworking Poles to blame for the UK real estate bubble?

The answer to the question of course is no, but let me tell the story anyway. It is a story about positive supply shocks, inflation targeting, relative inflation and bubbles.

In 2004 Poland joined the EU. That gave Poles the possibility to enter the UK labour market (and other EU labour markets). It is estimated that as much as half a million poles have come to work in the UK since 2004. The graph below shows the numbers of Poles employed in the UK economy (I stole the graph from Wikipedia)









Effectively that has been a large positive supply shock to the UK economy. In a simple AS/AD model we can illustrate that as in the graph below.

Positive supply shock

The inflow of Polish workers pushes the AS curve to the right (from AS to AS’). As a result output increases from Y to Y’ and the price level drops to P’ from P.

Imagine that we to begin with is exactly at the Bank of England’s inflation target of 2%.

In this scenario a positive supply – half a million Polish workers – will push inflation below 2%.

As a strict inflation targeting central bank the BoE in response will ease monetary policy to push inflation back to the 2% inflation target.

We can illustrate that in an AS/AD graph as a shift in the AD curve to the right (for simplicity we here assume that the BoE targets the price level rather than inflation).

The BoE’s easing will keep that price level at P, but increase the output to Y” as the AD curve shifts to AD’. Note that that assumes that the long-run AS curve also have shifted – I have not illustrated that in the graphs.

Positive supply shock and demand shock

At this point the Austrian economist will wake up – because the BoE given it’s monetary easing in response to the positive supply shock is creating relative inflation.

Inflation targeting is distorting relative prices

If we just look at this in terms of the aggregate price level we miss an important point and that is what is happening to relative prices.

Hence, the Polish workers are mostly employed in service jobs. As a result the positive supply shock is the largest in the service sector. However, as the service sector prices fall the BoE will push up prices in all other sectors to ensure that the price level (or rather inflation) is unchanged. This for example causes property prices to increase.

This is what Austrian economists call relative inflation, but it also illustrates a key Market Monetarist critique of inflation targeting. Hence, inflation targeting will distort relative prices and in that sense inflation targeting is not a “neutral” monetary policy.

On the other hand had the BoE been targeting the nominal GDP level then it would have allowed the positive shock to lead to a permanent drop in prices (or lower inflation), while at the same time kept NGDP on track. Therefore, we can describe NGDP level targeting as a “neutral” monetary policy as it will not lead to a distortion of relative prices.

This is one of the key reasons why I again and again have described NGDP level targeting as the true free market alternative – as NGDP targeting is not distorting relative prices contrary to inflation targeting,which distorts relative prices and therefore also distorts the allocation of labour and capital. This is basically an Austrian style (unsustainable) boom that sooner or later leads to a bust.

So is this really the story about UK property prices?

It is important to stress that I don’t necessarily think that this is what happened in the UK property market. First, of all UK property prices seemed to have taken off a couple of years earlier than 2004 and I have really not studied the data close enough to claim that this is the real story. However, that is not really my point. Instead I am using this (quasi-hypothetical) example to illustrate that central bankers are much more likely to creating bubbles if they target inflation rather than the NGDP level and it is certainly the case that had the BoE had an NGDP level targeting (around for example a 5% trend path) then monetary policy would have been tighter during the “boom years” than was actually the case and hence the property market boom would likely have been much less extreme.

But again if anybody is to blame it is not the half million hardworking Poles in Britain, but rather the Bank of England’s overly easing monetary policy in the pre-crisis years.

PS I am a bit sloppy with the difference between changes in prices (inflation) and the price level above. Furthermore, I am not clear about whether we are talking about permanent or temporary supply shocks. That, however, do not change the conclusions and after all this is a blog post and not an academic article.

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  1. I have never really understood why relative inflation is a problem in this situation.

    If inflation is kept at 2% by central bank intervention, this will raise ‘other sector’ prices, but it will also raise prices in the service sector, relative to the counterfactual.

    I don’t see why keeping inflation at 2% would lead to the other sectors making up a greater proportion of the general price level than in the counterfactual scenario.

  2. rob

     /  January 31, 2013


    I have a question. You show how the increase in the workforce causes prices to fall under NGDPT. This would include the price of labor. If wages (and other prices) are sticky would this not itself cause frictions in this scenario ?

    In a situation were the workforce is growing would you recommend that this be factored in to the NGDPT target ?

    • Rob,

      Regarding sticky wages that is a argument that you should target for example 5% NGDP growth rather than for example 0%.

      In terms of correcting for the development in the labour force I certainly think that there is an argument to be made that the central bank should target NGDP/capita.

  3. Nice theory Lars but it doesn’t pass the sniff test, every Brit “knows” all those hard-working Poles went into the construction industry. ;)

    (Actually more seriously a case for UK supply pessimists case is that service sector inflation was actually quite high for a long time, 3%+ from 2000 onwards; goods deflation, perhaps imported/strong pound, was “hiding” that problem.)

    • Britmouse,

      You shouldn’t look at the absolut level of service sector inflation, but instead on the relative inflation in the service sector compared to the rest of the economy. Furthermore, it is natural that service sector inflation is higher than overall inflation. This is known as the Baumol effect: Price increases are the highest in sector with the lowest productivity growth (think of the hairdresser). See here:'s_cost_disease

  4. British housing supply is highly constrained by regulation. Hence any positive demand shock (such as all those Poles wanting somewhere to live) drives up rents and prices. But the problem is the highly restrictive land regulation, which naturally creates price surges.

  5. Chun

     /  February 1, 2013

    It is a bizarre argument. I personally prefer NGDPLT to inflation targeting, but this argument a little bit puzzled me. Since inflation targeting policy is forward-looking, the Bank of England will not conduct an expansionary monetary policy to correct the deflation that has already occurred. Therefore, the price level will stay as it is after the given positive AS shock occurs. Of course, the Bank of England may conduct expansionary monetary policy if it expects a deflation. Still, I’m not sure why its inflationary effect will cause relative price changes. In the given argument, as service sector price falls, relative prices of other sectors fall and deflation occurs. Then, to correct deflation, the BOE pushes money into the economy. As a result, nominal income goes up (actual observation shows real income goes up too, but do not touch that issue.) Service sector prices will rise as proportionately as other sector prices rise. Then, if other things stays the same, the price ratio of service sector goods to other goods will not change. Am I wrong?

  6. Chun

     /  February 1, 2013

    one correction to myself” “as service sector price falls, relative prices of other sectors fall and deflation occurs” to “as service sector price falls, relative prices of other sector rise but the price level falls overall.”

  7. Becky Hargrove

     /  February 1, 2013

    Re: Baumol effect and services. Part of the problem with services now is a sort of Nash Equilibrium “rat race” between services and the construction based wealth that local communities seek to create through ever more stringent zoning and regulation. This newer dynamic has taken off as the older dynamic of cost push inflation has decreased in the unions associated with manufacturing. NGDPLT can greatly assist in pointing out the imbalances of any such dynamics.

    • Becky Hargrove

       /  February 1, 2013

      sorry I didn’t fully expain myself. That is my rationale for setting technology, robots, mass manufacture, economies of scale, 3D printing with recyclables or whatever it takes – loose on the building and construction industries.


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