Anecdotally, the role of migrant labour has increased in various sectors – partly associated with the enlargement of the EU’s single labour market. If that continued, with new residents continuing to help to meet particular skill shortages, the labour supply available to UK businesses would increase, implying that the economy could potentially accommodate stronger aggregate demand than otherwise. However, the available data do not really enable us to get beyond anecdote and speculation. Financing Another important input for firms is finance – for working capital and investment. Here too, there seem to have been changes – in the range and terms of the sources of finance available to both firms and households – that could potentially influence the extent of cyclical fluctuations in output and inflation. One characterisation of the past would be that firms and households depended on bank loans for external finance; and that banks loosened or tightened credit conditions sharply in the different phases  5  See, for example, Nickell S. and Quintini G.,(2002), ‘The recent performance of the UK labour market’, Oxford Review of Economic Policy, Vol. 6(4), pages 26-35. BIS Review 16/2005  3  of a business cycle, reining back when the economy suffered a downturn and arrears and losses mounted.
Inflation and firms’ price-setting behaviour In the medium-to-long run, the average rate of inflation is determined by the rate of nominal expansion permitted by the monetary authority. But over shorter horizons, decisions taken by businesses – in particular, about wages and prices – affect quarter-to-quarter fluctuations in inflation and, more generally, how demand pressures feed through to inflation. Economic policymakers draw on a number of ways of thinking about those influences on inflation dynamics. There is no model that can, uniquely, capture the richness of the real world. But surprising though it may be to some, one of the ways in which we think about firms’ price-setting behaviour would be familiar to anyone running a business. Namely, that firms charge a mark up, or profit margin, over the marginal costs of their various inputs – labour, capital, raw and intermediate materials, etc – with both the mark up and costs varying according to current and prospective demand conditions. This is represented schematically, indeed crudely, in Diagram 1. The key feature is that when demand rises and firms utilise their capacity more fully and add to their labour force, their costs and prices tend to rise. That might involve old-fashioned ‘cost-push’ inflation, with firms raising prices to maintain margins in the face of increased (marginal) costs. Or firms might initially be able temporarily to raise margins, with labour and other costs later ‘catching up’. In either case, firms and wage bargainers will be influenced by what they think is going to happen to inflation in the future.