A-LEVEL
Economics
Government Fiscal Policy
Fiscal policyinvolves the use ofgovernment spending, taxation
and borrowingto affect the level and growth of aggregate demand,
output and jobs
Fiscal policy is also used to change thepattern of spendingon
goods and services
It is also a means by which a redistribution of income &
wealth can be achieved
It is an instrument of intervention to correct for free-market
failures
Changes in fiscal policy affectaggregate demand(AD)andaggregate
supply(AS)
In the UK, the Treasury (pictured right) is in charge of fiscal
policy decisions
Fiscal Policy and Aggregate Demand
Traditionally fiscal policy has been seen as aninstrument of
demand management. This means that changes in government spending,
direct and indirect taxation and the budget balance can be
usedcounter-cyclicallyto help smooth out some of the volatility of
national output particularly when the economy has experienced
anexternal shockand is in a recession.
TheKeynesian schoolargues that fiscal policy can have powerful
effects on demand, output and employment when the economy is
operating below fullcapacitynational output, and where there is a
need to provide ademand-stimulus.
Monetarist economistsbelieve that government spending and tax
changes only have a temporary effect on aggregate demand, output
and jobs and that the tools ofmonetary policyare a more effective
instrument in controlling inflation and maintaining macroeconomic
stability
The fiscal policy transmission mechanism
This flow-chart identifies some of the channels involved with
the fiscal policy transmission mechanism in the example shown we
focus on an expansionary fiscal policy designed to boost demand and
output
Themultiplier effects of an expansionary fiscal policydepend on
how much spare productive capacity the economy has; how much of any
increase in disposable income is spent rather than saved or spent
on imports. And also the effects of fiscal policy on variables such
asinterest ratesAcontractionary fiscal policywould involve one or
more of the following:
A cut in government expenditure either in real terms or as a
share of GDP
An increase in direct and/or indirect taxes
An attempt to reduce the size of the budget deficit
Government spending
Government spending (or public spending) and in Britain, it
takes up over 45% of GDP. Spending by the public sector can be
broken down into three main areas:
Transfer Payments:
a. These arewelfare paymentsmade available through thesocial
security systemincluding the Jobseekers Allowance, Child Benefit,
State Pension, Student Grants, Housing Benefit, Income Support and
the Working Families Tax Credit
b. The main aim of transfer payments is to provide abasic floor
of incomeor minimum standard of living for low income households.
And they allow the government to change the final distribution of
income. In 2010-11 the UK government spent 196bn on welfare
benefits, equivalent to 13.4% of GDP
Current Government Spending: i.e. spending onstate-provided
goods & servicesthat are provided on a recurrent basis - for
example salaries paid to people working in the NHS and resources
for state education and defence. The NHS is the countrys biggest
employer with over one million people working within the
system!
Capital Spending: Capital spending includes infrastructure
spending such as new motorways and roads, hospitals, schools and
prisons. This investment spending adds to the economys capital
stock and can have important demand and supply side effects in the
long term.
The main items of UK government spending are shown in the pie
chart below- the data is taken from the March 2011 UK Budget
Statement available from the HM Treasury website.Social
protectionis the biggest single component of departmental spending
and includes the many welfare benefits paid to recipients including
the state pension, the jobseekers allowance, income support and
housing benefit.
Economic and Social Justifications for Government Spending To
provide a socially efficient level ofpublic goods and merit
goodsand overcome market failure
a. Public goods and merit goods tend to be under-provided by the
private sector
b. Improved and affordable access to education, health, housing
and other public services can help to improve human capital, raise
productivity and generate gains for society as a whole
To provide asafety-net system of welfare benefitsto supplement
the incomes of the poorest in society this is also part of
theprocess of redistributing income andwealth. Government spending
has an important role to play in controlling / reducing the level
of relative poverty
To providenecessary infrastructurevia capital spending on
transport, education and health facilities an important component
of a countrys long runaggregate supply Government spending can be
used tomanage the level and growth of ADto meet macroeconomic
policy objectives such as low inflation and higher levels of
employment
Government spending can be justified as a way of promoting
equity. Well targeted and high value for money public spending is
also a catalyst for improving economic efficiency and macro
performance.
Taxation
Direct taxationis levied onincome, wealth and profit. Direct
taxes include income tax, inheritance tax, national insurance
contributions, capital gains tax, and corporation tax.
Indirect taxesare taxes on spending such as excise duties on
fuel, cigarettes and alcohol and Value Added Tax (VAT) on many
different goods and services
What are the main sources of tax revenues for the UK
government?The table below shows the annual revenue from the main
taxes in the UK.
Category of TaxTax Revenue in 2010-11
Income tax153.3
National insurance contributions97.7
Value added tax86.3
Corporation tax43.0
Fuel duties27.3
Council tax25.7
Business rates23.3
Tobacco duties9.1
Stamp duty land tax6.0
Vehicle excise duties5.8
Beer and cider duties3.7
Capital gains tax3.6
Source: Office for Budgetary Responsibility, March 2012
Progressive, proportional and regressive taxes and the
distribution of income With aprogressive tax,the marginal rate of
tax rises as income rises. I.e. as people earn more income, the
rate of tax on each extra pound goes up. This causes a rise in the
average rate of tax
With aproportional tax, the marginal rate of tax is constant.
National insurance contributions are the closest example in the UK
of a proportional tax, although low-income earners do not pay NICs
below an income threshold
With aregressive tax, the rate of tax falls as incomes rise I.e.
the average rate of tax is lower for people of higher incomes. In
the UK, regressive taxes come from excise duties of items of
spending such as cigarettes and alcohol. Indirect taxes form a
larger percentage of the disposable income of those who earn less,
even though they may also spend less
Income TaxIncome tax in the UK isprogressive here are the
current tax rates(correct to the end of 2011) Most people have a
tax free personal allowance worth 7,475 (up to an annual income of
100,000)
Basic rate of income tax = 20% on incomes up to 37,000
Higher rate of income tax = 40%
A top rate of 50% applies to income over 150,000
As income rises, the rate of tax rises so that people on the
highest incomes will pay a higher percentage of their income to the
government. The progressivity of the income tax system for the UK
is shown in the table below. People with an annual income greater
than 1 million will pay a tax rate of over 44%.
Corporation TaxThis is a tax on business profits. There is a tax
free allowance for businesses making low annual profits
Small Profits Rate (for businesses with profits < 300,000) =
20%
Main rate of Corporation Tax = 25%
Value Added Tax (VAT)Value Added Tax (VAT) is a tax that's
charged on most goods and services that VAT-registered businesses
provide in the UK. It's also charged on goods and some services
that are imported from countries outside the European Union (EU),
and brought into the UK from other EU countries
There are three rates of VAT, depending on the goods or services
the business provides. The rates are:
Standard - 20 per cent
Reduced - 5 per cent i.e. energy bills
Zero - 0 per cent (i.e. exempt) including childrens clothes,
congestion charge, doctors fees
Automatic stabilisers and discretionary changes in fiscal
policyDiscretionary fiscal changesaredeliberate changesin direct
and indirect taxation and govt spending for example, increased
capital spending on roads or more resources going into the NHS.
Automatic stabilisersare changes in tax revenues and government
spending that come about automatically as an economy moves through
the business cycle
Tax revenues:When the economy is expanding rapidly the amount of
tax revenue increases which takes money out of the circular flow of
income and spending
Welfare spending:A growing economy means that the government
does not have to spend as much on means-tested welfare benefits
such as income support and unemployment benefits
Budget balance and the circular flow:A fast-growing economy
tends to lead to a net outflow of money from the circular flow.
Conversely during a slowdown or a recession, the government
normally ends up running a largerbudget deficit.
Fiscal Policy andAggregate SupplyIt is important to understand
that fiscal policy can have important effects on thesupply-side of
the economy. Indeed many government fiscal decisions are made with
improving the supply-side in mind.
The current Coalition government has launched aGrowth Review a
set of policies that aims to drive stronger GDP growth in the UK as
the economy struggles to emerge from the recession. Many of their
aims require the active use of fiscal policy to boost supply-side
incentives, investment and efficiency.
Labour market incentives:a. Changes in income tax can improve
incentives for people to actively look for work
b. Lower taxes might also have a positive effect on work effort
and labour productivity
c. Cuts to national insurance contributions might help to expand
the active labour supply
d. Some economists argue thatwelfare benefit reformsare more
important than tax cuts in improving incentives to create a gap
between the incomes of people in a job and the unemployed. Some
people favour reducing the relative value of benefits as a way of
improving incentives. Others favour a move towards targeted
benefits where the transfer payment is linked to participation in
employment schemes or community work
Capital spending:
a. Spending oninfrastructure(e.g. improvements to our motorway
network or an increase in the building programme for new schools
and hospitals) helps provide the capacity needed for other
businesses to flourish.
b. Lower rates of corporation tax and other business taxes might
attract inward investment from overseas. An aim of the UK
government is to have the lowest corporate tax rate in the G7 and
among the lowest in the G20 nations Entrepreneurship and
investment:
a. Government spending can be used to fund an expansion in new
small business start-ups
Research and development andinnovation:
a. Government spending, tax credits and other tax allowances
could be used to encourage research and development to improve
competitiveness and contribute to a faster pace of innovation and
invention
b. A key aim going forward is to use tax incentives to stimulate
an increase in investment in low carbon technologies to promote
green growth
Human capitalof the workforce:
a. Spending on education and increased investment in health and
transport can also have important supply-side effects in the long
run
b. Government spending on youth apprenticeships can help to
improve human capital, employability and productivity giving more
younger people the chance to make a strong start when they enter
the labour market
The Free Market AgendaFree market economistsare sceptical of the
effects of government spending in improving the supply-side of the
economy. They argue that lower taxation and tight control of
government spending and borrowing is required to allow the private
sector of the economy to flourish. They believe in a smaller sized
state sector so that in the long run, the overall burden of
taxation can come down and thus allow the private sector of the
economy to grow and flourish.
Economics of a Budget (Fiscal) Deficit When the government is
running abudget deficit, it means that in a given year, total
government expenditure exceeds total tax revenue
If the government is running a budget deficit, it has to borrow
this money through the issue of debt such as Treasury bills and
bonds
Most of the government debt is bought up by financial
institutions but individuals can buy bonds, premium bonds and buy
national savings certificates
The budget balance is the annual difference between tax revenues
and government spending
Gross government debt is the total accumulated debt owed by the
government this is also known as the national debt
The UK government last had a budget surplus in the year 2000 but
it has run budget deficits in every year since then.
There was a large rise in the budget deficit from 2008 onwards
because of the recession and also attempts by the government to
stimulate the economy. The deficit peaked at over 10% of GDP and
been declining gradually since.
Does a budget deficit matter?A persistently largebudget
deficitcan be a problem:
Financing a deficit:a. If the budget deficit rises to a high
level, the government may have to offer higher interest rates to
attract sufficient buyers of debt.
b. This raises the possibility of the government falling into
adebt trapwhere it must borrow more to repay the interest on
accumulated borrowing.
c. Many high debt countries in the European Union have suffered
from this in recent years high profile examples have included
Ireland, Greece, Spain and Portugal.
A government debt mountain:a. Annual budget deficits over a
number of years will cause the total amount of unpaid government
debt to climb.
b. There is anopportunity costinvolved because interest payments
on bonds might be used in more productive ways, for example on
health services or extra investment in education. Every 0.05% saved
on 220bn of new debt pays one years salary for 46,000 teachers.
c. Higher public sector debt also represents atransfer of
incomefrom people and businesses that pay taxes to those who hold
government debt and cause a redistribution of income and wealth in
the economy.
Crowding-out:a. If a larger budget deficit leads to higher
interest rates and taxation in the medium term and thereby has a
negative effect on growth in consumption and investment spending,
then a process of fiscal crowding-outis occurring
b. The Institute of Fiscal Studies has estimated that reducing
the UK budget deficit over the next five years will require every
person in the UK to pay 1250 of extra taxes each year.
Risk of capital flight:
a. Some economists believe that high borrowing risks causing a
run on a domestic currency. This is because the government may find
it difficult to find sufficient buyers of its debt and the
credit-rating agencies may decide to reduce the rating on a nations
sovereign debt
Potential benefits of a budget deficit1. Government borrowing
can benefit growth:a. A budget deficit can have positive
macroeconomic effects if it is used to finance capital spending
that leads to an increase in thestock of national assetsb. For
example, spending on transportinfrastructureimproves thesupply-side
capacity and productivity of the economyc. Improved provision of
public goods can create positive externalities
2. The budget deficit as a tool of demand management:a.
Keynesian economists support borrowing as a way of
managingaggregate demandb. An increase in borrowing can be auseful
stimulus to demandwhen other sectors of the economy are suffering
from weak or falling spending
c. A change in the government budget deficit may lead to a more
than proportional change in aggregate demand this is known as
thefiscal multiplier effect.
Cutting the deficit the Coalition policies The Coalition
Government wants to halve the budget deficit over a five year
period
They have launched a programme offiscal austerityamounting to
126 billion a year of combined spending cuts and tax rises
Most of the fiscal austerity is coming through planned
reductions in the real level of government spending. 80% will come
from spending reductions, 20% is forecast to come from higher
taxes
The fiscal squeeze is highly controversial and has led to an
impassioned debate among economists about the best way to control a
budget deficit as an economy struggles to lift itself out of
recession and sustain a recovery.
Keynesian economistsargue that deficit-reduction policies risk
driving the economy into a second recession known as adouble-dip.
Reducing spending or raising taxes could hurt an already fragile
economy and make the fiscal deficit problem even worse. They doubt
whether new job creation in the private sector is likely to be able
to compensate for job losses in the public sector.
Keynesians believe that economic growth will help bring down the
deficit and that maintaining a sufficiently high level of demand is
crucial to achieving this public expenditure is a component of
aggregate demand and hence if public expenditure falls so will
aggregate demand C+I+G+X-M). Many private sector jobs depend on
public sector spending, for example workers in the construction
industry who build new roads or social housing.
The government believes that reducing the budget deficit is
possible without causing another downturn and that cutting the
budget deficit is important to maintain their economic credibility
in financial markets. Cuts in public spending are unavoidable given
the size of the budget deficit. Their strategy relies less heavily
on tax increases; indeed some taxes have been cut in a bid to
stimulate private sector investment
Monetary Policy Monetary policyinfluences the decisions that we
make about how much we save, borrow and spend
Decisions made by the central banks that operate monetary policy
can have a powerful effect on consumers and businesses
Changes in interest rates have both demand and supply-side
effects.
What is Money?
Money is any asset that is acceptable as a medium of exchange in
payment for goods and services. The functions of money are as
follows:
Amedium of exchangeused in payment for goods and services
Aunit of accountused to relative measure prices and draw up
accounts
Astandard of deferred payment for example when using credit to
purchase goods and services now but pay for them later
Astore of value- money holds its value unless there is a
situation of accelerating inflation. As the general price level
rises, so the internal value of a unit of currency decreases.
Interest Rates
The media often talks about interest rates going up, or interest
rates going doing as if there was one single or unique rate of
interest in the economy. That isnt true indeed there are thousands
of different rates in the financial markets it can get
confusing!
For example we distinguish betweensavings ratesandborrowing
rates, interest rates on secured and unsecured loans and short term
and long term interest rates on different forms of savings
account.
However we find that interest rates tend to move in the same
direction. For example if theBank of Englandcuts the base rate of
interest then we expect to see commercial banks cutting the rates
on their loans and lower rates are offered on savings accounts with
Banks and Building Societies.
The Real Rate of Interest
Thereal rate of interestis important to businesses and consumers
when making spending and saving decisions
The real rate of return on savings, for example, is the money
rate of interest minus the rate of inflation. So if a saver is
receiving a money rate of interest of 6% on his savings, but price
inflation is running at 3% per year, the real rate of return on
these savings is only + 3%.
Real interest rates become negative when the nominal rate of
interest is less than inflation, for example if inflation is 5% and
nominal interest rates are 4%, the real cost of borrowing money is
negative at -1%.
The Bank of England and the operation of Monetary Policy
Founded in 1694, nationalized in 1946, the Bank of England is
charged with providing monetary and financial stability for the
United Kingdom
TheBank of Englandhas been independent since 1997
The Monetary Policy Committee (MPC) has nine members, some of
whom are appointed by the government and some by the Bank of
England. The Governor of the Bank has the casting vote if there is
an equally split decision on interest rates
Each month the MPC meets to consider the latest news on the UK
and global economy
Their job is to make a judgement on what is the appropriate
level of base interest rates for theUK economyconsistent with the
need to meet aninflation targetset by the government
That inflation target isconsumer price inflationof 2%
The MPC has one eye on maintaining growth (although a set rate
of GDP growth isnotpart of their target). Inflation is allowed to
vary by 1% either side of the 2% target so they have some
leeway.
Official UK interest rates in recent years
Factors considered when setting interest rates
At each of their rate-setting meetings, the members of the MPC
consider a huge amount of information on the state of the economy.
Here are some of the factors they consider when making rate
decisions.
GDP growth and sparecapacity: The rate of growth of GDP and the
size of theoutput gap. Their main task is to set monetary policy so
that AD grows in line with productive potential.
Bank lending and consumer credit figures- including the levels
of equity withdrawal from the housing market and also data on
credit card lending which supports consumer demand
Equity markets (share prices) andhouse prices- both are
considered important in determining household wealth, which then
feeds through to borrowing and retail spending. The monetary policy
committee has no official target for the annual rate ofhouse price
inflationbut it has been criticized for not doing enough to prevent
the housing bubble in Britain up to 2008.
Consumer confidenceand business confidence confidence surveys
can provide advance warning of turning points in the economic
cycle. These are called leading indicators.
Growth of wages, average earnings and unit labour costs- wage
inflation might be a cause of cost-push inflation so the Bank of
England looks carefully at what is happening to wages
Unemployment figures- and survey evidence on the scale of
shortages of skilled labour.
Trends in global foreign exchange markets a weaker exchange rate
could be seen as a threat to inflation because it raises the prices
of imported goods and services. A strong exchange rate might bring
down inflation but risk causing a deeper economic slowdown via a
fall in exports
International data- including recent developments in the Euro
Zone, emerging market countries and the United States and
Japan.
The key point is that the Monetary Policy Committee considers
many indicators from both the demand and the supply-side of the
economy.They then have to make a judgement about what this evidence
says aboutinflationary pressuresover a two year forecast
horizon.Why do they have to look up to two years ahead? Because
when interest rates are changed, it takes time for them to have an
effect on aggregate demand and prices. Uncertain time lags in a
world of many external economic shocks make the handling of
monetary policy a difficult job!
What are the main effects of changes in interest rates?
Before we look at the impact of rate changes, it is worth
remembering that when the Bank is making a decision, there will be
lots of other events and policy decisions being made elsewhere in
the economy, for example changes in fiscal policy by the
government, or perhaps a change in world oil prices or the exchange
rate. In macroeconomics theceteris paribusassumption (all other
factors held equal) rarely applies! There are several ways in which
changes in interest rates influence aggregate demand, output and
prices. These are collectively known as thetransmission mechanism
of monetary policy
One of the channels that the Monetary Policy Committee in the UK
can use to influence aggregate demand, and inflation, is via
thelending and borrowing ratescharged in the financial markets.
When the Banks own base interest rate goes up, then commercial
banks and building societies will typically increase how much they
charge on loans and the interest that they offer on savings.
This tends to discourage businesses from taking out loans to
finance investment and encourages the consumer to save rather than
spend and so depresses aggregate demand
Conversely, when the base rate falls, banks cut the market rates
offered on loans and savings and the effect ought to be a stimulus
to demand and output.
A key influence played by interest rate changes is the effect
onconfidence in particular households confidence about their own
personal financial circumstances.
Changes in interest rates affect:
Housing market & house prices:
a. Higher interest rates increase the cost of mortgages and
reduce the demand for most types of housing. This will affect
householdwealthand put a squeeze onequity withdrawal(where
consumers borrow money secured on rising house prices) which adds
directly to consumer spending.
Effective disposable incomes of mortgage payers:
a. If interest rates increase, the income of homeowners who have
variable-rate mortgages will fall leading to a decline in their
effective purchasing power
b. The effects of a rate change are greater when the level of
existing mortgage debt is high as this makes property owners more
exposed to higher costs of repaying debts.
Disposable income of savers:
a. A rise in interest rates boosts the disposable income of
people who have paid off their mortgage and who have positive net
savings in bank and building society accounts
b. But if the rate of interest is lower than the rate of
inflation, then the annual real return on saving will be
negative.
Consumer demand for credit:
a. Higher interest rates increase the cost of paying the debt on
credit cards and should lead to a deceleration in retail sales and
spending on consumer durables especially items such as cars and
household appliances which are typically bought on credit.
Businesscapital investment:
a. Firms often take the actual and expected level of interest
rates into account when deciding whether or not to go ahead with
new capital investment spending
b. A rise in interest rates may dampenconfidenceand lead to a
reduction in planned capital investment. However, many factors
influence investment decisions other than rate changes.
Consumer and business confidence:
a. The relationship between interest rates and business and
consumer confidence is complex, and depends crucially on prevailing
economic conditions
b. For example, when businesses and consumers are worried about
the recession, an interest rate cut can boost confidence because it
reassures the public that the Bank is alert to the dangers of a
slump
c. Some people might take emergency interest rate cuts as a sign
that the wider economy is in difficulty and hard times lie
ahead.
Interest rates and theexchange rate:
a. The link between interest rates and movements in the external
value of a currency are important to understand at AS level.
b. Higher UK interest rates might lead to an appreciation of the
exchange rate particularly if UK interest rates rise relative to
those in the Euro Zone and the United States attracting inflows
ofhot moneyinto the British banking system.
c. A stronger exchange rate reduces the competitiveness of
UKexportsin overseas markets because it makes our exports appear
more expensive when priced in a foreign currency leading to a
decline in export volumes and market share.
d. It also reduces the sterling price of imported goods and
services leading to lower prices and rising import penetration. If
thetrade deficitin goods and services widens, this is a net
withdrawal of demand from the circular flow and acts to reduce
excess demand in the economy.
Key points:
A reduction in interest rates and/or an increase in the supply
of money and credit in an economy is called an expansionary
monetary policy or a reflationary monetary policy
An increase in interest rates and/or attempts to control or
reduce the supply of money and credit is called a contractionary
monetary policy or a deflationary monetary policy
Over the last few decades, monetary policy has been the main
policy instrument for managing the level and rate of growth of
aggregate demand and inflationary pressures
Monetary Policy Asymmetry
Fluctuations in interest rates do not have a uniform impact on
the economy. Some industries are more affected by interest rate
changes than others, for example exporters and industries connected
to the housing market. And, some regions are also more sensitive to
a change in the direction of interest rates.
The markets and businesses most affected by changes in interest
rates are those wheredemand is interest elasticin other words,
demand responds elastically to a change in interest rates or
indirectly through changes in the exchange rate
Good examples ofinterest-sensitive industriesinclude those
directly linked to the housing market exporters of manufactured
goods, the construction industry and leisure services
In contrast, the demand for basic foods and utilities is less
affected by short term fluctuations in interest rates and is
affected more by changes in commodity prices such asoil and
gas.
Ultra low interest rates in the UK from 2009-2012
The Bank of England started cutting monetary policy interest
rates in the autumn of 2008 as thecredit crunchwas starting to bite
and business and consumer confidence was taking a huge hit. By the
start of 2009 rates were down to 3% and they carried on falling
By the summer of 2009 the policy interest rate in the UK was
0.5% and theBank of Englandhad reached the point of no return when
it comes to cutting interest rates
The decision to reduce official base rates to their minimum was
in response to evidence of a deepening recession and fears of price
deflation
Ultra-low interest rates are an example of an expansionary
monetary policy i.e. a policy designed to deliberately boost
aggregate demand and output. At the time of writing (August 2012)
official base interest rates have stayed at 0.5% for over two and a
half years and there are few signs that they will increase
significantly in the near term.
In theory cutting interest rates close to zero provides a big
monetary stimulus this means that:
Mortgage payers have less interest to pay increasing their
effective disposable income
Cheaper loans should provide a possible floor for house prices
in the property market
Businesses will be under less pressure to meet interest payments
on their loans
The cost of consumer credit should fall encouraging the purchase
of big-ticket items such as a new car or kitchen
Lower interest rates might cause a depreciation of sterling
thereby boosting thecompetitivenessof the export sector
Lower rates are designed to boost consumer and
businessconfidenceBut some analysts argue that in current
circumstances, a period of low interest rates has little impact on
demand. Several reasons have been put forward for this:
The unwillingness of banks to lend most banks have become
risk-averse and they have cut the size of their loan books and
making credit harder to obtain
Low consumer confidence people are not prepared to commit to
major purchases because the recession has made people risk averse.
Weak expectations lower the effect of rate changes on consumer
demand i.e. there is a low interest elasticity of demand.
Huge levels of debt still need to be paid off including over
200bn on credit cards
Falling or slowing rise asset prices makes it unlikely that
cheap mortgages will provide an immediate boost to the housing
market.
Although official monetary policy interest rates are now close
to zero, the rate of interest charged on loans and overdrafts has
actually increased the cost of borrowing using credit cards and
bank loans is a high multiple of the policy rate. Little wonder
that many smaller businesses have complained that the Bank of
Englands policy of cheap money has done little to improve their
situation during the recession and in the early stages of the
recovery.
In March 2009 the Bank of England started a policy
ofquantitative easing(QE) for the first time. QE is also called as
asset purchase scheme or a bond purchase scheme
The aim of QE is to support demand in the economy and prevent a
period when inflation is persistently below target or becomes
negative (deflation).
The Bank of England can use QE to increase thesupply of money in
the banking system.
The media call this printing money but this is only true in an
electronic sense the Bank does not actually print new 10, 20 and 50
notes in an attempt to inject cash into the economic system.
Under thisunconventional strategy, the MPC discusses each month
how manyassets, including government bonds, to buy with central
bank money. This money is simply created by the central bank and is
the equivalent of turning on the printing press.
Quantitative easing has been used by other central banks
including the USA Federal Reserve
There are doubts about the effectiveness of quantitative easing
bank lending has struggled to recover since the end of the
recession despite bond purchases totalling 375bn as of July
2012
Funding for Lending Scheme (FLS)
This was introduced in 2012 as a new policy designed to increase
the supply of credit in the British economy. The FLS offers banks
and other lenders cheap funding (lower interest rates) secured
against some of their assets (known as collateral) if they agree to
lend on to businesses and home-buyers.
Some Evaluation Points on Interest Rates
Time lagsshould always be considered when analyzing the effects
of interest rate changes.
Monetary policy is not an exact science what happens in the
macro-economy is the result of millions of decisions taken by
households and businesses. We cannot predict with great accuracy
the extent to which a change in interest rates will achieved the
desired / planned economic effects
When it comes to inflation targeting there aremany factors
affecting costs and pricesand most of these are outside of the Bank
of Englands direct control e.g. changes in international commodity
prices and fluctuations in the exchange rate (see the next
chapter)
Monetary policydoes not work in isolation! Always remember
consider how the governments fiscal policy is affecting demand and
inflationary pressures.
Changes in interest rates can have an important effect on
thedistribution of income and wealthin a country. This is discussed
briefly below:
Interest rates and the distribution of income and wealth
Consider the effect of a fall in interest rates throughout an
economy
The real income of savers:
If the rate of interest paid on savings falls below the rate of
inflation, then people with positive net savings will see a
reduction in their real incomes
This has become a major policy issue in recent years with
interest rates on deposit accounts collapsing in the UK. Rising
inflation and falling interest rates have dealt a double-blow to
millions of savers many of whom are older and reliant on savings as
a source of income. The return is even lower when we consider that
most savers pay 20% tax on any interest. Some pay 40% or 50% on
their savings interest.
The disposable incomes of mortgage-payers:
If interest rates fall, the income of home-owners who have
variable-rate mortgages will increase leading to an rise in their
purchasing power
Interest rates, house prices and wealth:
Many factors affect house prices but when the cost of a mortgage
falls, standard theory predicts that the demand for housing will
expand driving property values higher.
This increases the net financial wealth of people who own
property but makes it more difficult for lower-income families
including many young people to find the money to afford to purchase
a house or flat.
In summary - when interest rates fall, there is are-distribution
of incomeaway from lenders (who receive less) towards those with
variable rate loans.
People with positive net savings also stand to lose out from big
cuts in interest rates. Little wonder that the Governor of the Bank
of England gets many letters of complaints from pensioners when
interest rates are cut or remain low for long periods of time!
Unemployment
Who is unemployed?
The unemployed are people able, available and willing to work at
the going wage rate but cannot find a job despite anactive search
for work
Unemployment means that scarce human resources are not being
used to produce goods and services to meet peoples needs and
wants
Persistently high levels of joblessness have damaging
consequences for an economy causing both economic and social
costs
Problems caused by unemployment occur across a country but are
often very bad and deep-rooted in local and regional communities
and within particular groups of society for example in the UK, more
than one in six young people are out of work. The figure is much
higher in Greece and Spain.
Measuring unemployment
TheClaimant Countmeasure includes people who are eligible to
claim the Job Seeker's Allowance (JSA). The data is seasonally
adjusted to take into account predictable seasonal changes in the
demand for labour.
TheLabour Force Surveycounts those who are without any kind of
job including part time work but who have looked for work in the
past month and are able to start work immediately. The figure
includes those people who have found a job and are waiting to start
in the next two weeks.
On average, the labour force survey measure has exceeded the
claimant count by about 500,000 in recent years. Because it is
asurvey- albeit a large one and one that provides a rich source of
data on the employment status of thousands of households across the
UK - there will always be asampling error in the data.
The Labour Force Survey uses the internationally agreed
definition of unemployment and therefore best allows cross-country
comparisons of unemployment levels among developed countries.
Are we measuring unemployment accurately?
1 / Discouraged workers
No measure of unemployment is ever completely accurate since
there are some people out of work but looking for a job who are not
picked up by the official statistics
Official unemployment data misses out the hidden unemployed - an
example arediscouraged workerswho have been out of work for a long
time and who have stopped applying forjobs2 / economically inactive
people who arenot actively looking for work some of the reasons
include:
The need to look after elderly or infirmed relatives
Parents who are full-time carers for their children
People who have taken early retirement
3 / Under-employment:In many countries data may ignore the
extent ofunder-employment, for example people who want full-time
work but have to settle for a part-time job. In many lower-income
countries the quality of the labour market data may be poor causing
published figures to be inaccurate.
There are big differences in unemployment rates across the UK
why do you think some regions suffer from persistently higher
jobless problems?
Types and Causes of Unemployment
Frictional Unemployment
Frictional unemployment istransitional unemploymentas people
move between jobs: For example, newly-redundant workers or people
joining the labour market for the first time such as university
graduates may take time searching to find work they want at wage
rates they are prepared to accept.
Imperfect informationin the labour market may make frictional
unemployment worse if the jobless are unaware of the available
jobs.
Incentives problemscan also cause frictional unemployment as
some people may stay out of work if they believe the tax and
benefit system leaves them little or no better off from taking a
job
When there aredisincentivesfor people to accept work, this is
known as theunemployment trap.
Frictional unemployment happens when it takes time for a
countrys labour market to match the available jobs with people
seeking work. The chart below shows the monthly level ofunfilled
vacanciesin the UK. For most of the current decade there have been
between 500,000 and 700,000 unfilled vacancies.
The recession caused a steep decline in the number of available
jobs and by the summer of 2010 there were fewer than 500,000
unfilled posts set against a much larger pool of unemployed. The
result is that the ratio of unemployed to job vacancies has grown,
meaning that there are many people chasing each available job. This
makes it tough to get back into paid work.
Structural Unemployment
Structural unemployment happens when there is along-term decline
in demand in an industryleading to fewer jobs being available as
the demand for labour falls away this leads to a decline in
employment in a particular industry (sector) or a particular
occupation. Examples might include:
Jobs on a production line being replaced by robots e.g. motor
manufacturing
Unemployment caused by foreign competition (or changes in
comparative advantage)
Structural unemployment exists where there is amismatchbetween
their skills and the requirements of the new job opportunities.
This problem is due tooccupational and geographical immobility of
labourand requires investment to improve skills, give the
unemployed suitable training and work experience and make them able
to move location if needed to take a new job.
Globalisationinevitably leads to changes in the patterns of
trade between countries. Britain has probably now lost a cost
advantage inmanufacturinggoods such as motor cars, household goods
and audio-visual equipment, indeed our manufacturing industry has
lost jobs as some production has shifted to lower-cost centres in
Eastern Europe and emerging market countries in Far East Asia.
Many of these workers may suffer from a period of structural
unemployment, particularly if they are in regions of above-average
unemployment rates where job opportunities are scarce.
Employment in UK manufacturing industries has fallen year on
year for nearly three decades. Since the turn of the century, over
1.5 million jobs have been lost in the manufacturing sector the
decline was amplified by the effects of recession in 2008-2010
although there are tentative signs that manufacturing employment,
investment and employment may now be picking up.
Jobs lost in manufacturing and construction creates problems of
structural unemployment, but this is a cause of unemployment that
can affect people in all sectors of the economy.
Cyclical Unemployment:
Cyclical unemployment isinvoluntary unemploymentdue to a lack of
demand for goods and services. This is also known asKeynesian
unemploymentordemand-deficient unemployment
When there is a recession or a steep slowdown in growth, we see
a rising unemployment because of plant closures, business failures
and an increase in worker lay-offs and redundancies. This is due to
a fall in demand leading to a contraction in output across many
industries.
Firms are likely to reduce employment to cut costs and/or
maintain profits this is called labour shedding or down-sizing
The economy does not have to go into recession for cyclical
unemployment to start rising. Many jobs can be lost even in a
slowdown phase and one reason for this is because of
risingproductivity. Say for example that a countrys GDP is
expanding at 1 per cent a year but output per worker is growing by
3 per cent. This means that the same national output can be
produced using fewer workers.
Inflation
Inflationis asustained increase in the cost of living or the
average / general price levelleading to a fall in thepurchasing
power of money.
The opposite of inflation is deflation which is a decrease in
the cost of living or average price level.
How is the rate of inflation measured?
Therate of inflationis measured by the annual percentage change
in consumer prices.
The British government has set aninflation targetof 2% using
theconsumer price index(CPI)
It is the job of theBank of Englandto set interest rates so that
aggregate demand is controlled, inflationary pressures are subdued
and the inflation target is reached
The Bank is independent of the government with control of
interest rates and it is free from political intervention.The Bank
is also concerned to avoidprice deflation we return to this a
little later.
Falling inflation does not mean falling prices!
Please remember that afall in the rate of inflationis not the
same thing as afall in prices! Have a look at the chart above which
measures the rate of consumer price inflation for the UK. Notice
how in 2009 there was a steep drop in inflation from 5 per cent to
1 per cent over the course of the year. Inflation was falling but
the rate remained positive meaning that prices were rising but at a
slower rate! A slowdown in inflation is not the same as deflation!
For this to happen, inflation would have to be negative.How is the
rate of inflation calculated?
Thecost of livingis a measure of changes in the average cost of
buying a basket of different goods and services for a typical
household
In the UK there are two measures, theRetail Price Index(RPI)
& theConsumer Price Index(CPI).
The major difference between the two measures, is that CPI
calculations excludes payments on mortgage interest - it is thought
that by excluding mortgages, the CPI is a better measure of the
impact of macroeconomic policy
The CPI is aweighted price index. Changes in weights reflect
shifts in the spending patterns of households in the British
economy as measured by the Family Expenditure Survey.
The price index for this year is:the sum of (price x weight) /
sum of the weights
So the price index for this year is 104.1 (rounding to one
decimal place)
The rate of inflation is the % change in the price index from
one year to another.
So if in one year the price index is 104.1 and a year later the
price index has risen to 112.5, then the annual rate of inflation =
(112.5 104.1) divided by 104.1 x 100. Thus the rate of inflation =
8.07%.
Limitations of the Consumer Price Index as a measure of
inflation
The CPI is not fully representative:
Since the CPI represents the expenditure of the average
household, inevitably it will be inaccurate for the non-typical
household, for example, 14% of the index is devoted to motoring
expenses - inapplicable for non-car owners.
Single people have different spending patterns from households
that include children, young from old, male from female, rich from
poor and minority groups.
We all have our own weighting for goods and services that does
not coincide with that assigned for the consumer price index.
Housing costs:The housing category of the CPI records changes in
the costs of rents, property and insurance, repairs. It accounts
for around 16% of the index. Housing costs vary greatly from person
to person.
Changing quality of goods and services: Although the price of a
good or service may rise, this may also be accompanied by an
improvement in quality as the product. It is hard to make price
comparisons of, for example, electrical goods over the last 20
years because new audio-visual equipment is so different from its
predecessors. In this respect, the CPI may over-estimate inflation.
The CPI is slow to respond to the emergence of new products and
services.
Our chart above illustrates sub-sections of the UK consumer
price index. The base year for the calculation is 2005 so prices in
January 2005 are given an index number of 100. Since then overall
the consumer price index has increased by nearly 24% but energy
prices (e.g. electricity and gas bills) have jumped by much more
whereas there has been persistent and deep deflation in the prices
of many audio-visual products.
Deflation
Price deflationhappens when therate of inflation becomes
negative. I.e. the general price level is falling and the
purchasing power of say 1,000 in cash is increasing
Some countries have experienced periods of deflation in recent
years; perhaps the most well-known example was Japan during the
late 1990s and in the current decade. In Japan, the root cause of
deflation was slow growth and ahigh level of spare capacitythat was
driving prices lower.
Hyperinflation
Hyperinflationis extremely rare. Recent examples include
YugoslaviaArgentina,Brazil,GeorgiaandTurkey(where inflation reached
70% in 1999)
The classic example of hyperinflation was therampant inflation
in Weimar Germany between 1921 and 1923.
When hyperinflation occurs, the value of money becomes worthless
and people lose all confidence in money both as astore of valueand
also as amedium of exchange
Therecent hyperinflation in Zimbabweis a good example of the
havoc that can be caused when price inflation spirals out of
control. It has made it virtually impossible for businesses to
function in any kind of normal way.
For Britain the worst inflation experienced in modern times was
during themid to late 1970swhen prices were rising at an annual
rate of over twenty per cent. At the same time the economy was
suffering from slow growth and rising unemployment and this gave
rise to the idea ofstagflation.
Understanding the main causes of inflation
Inflation can come from both thedemandand thesupply-sideof an
economy
Inflation can arise frominternalandexternalevents
Some inflationary pressures direct from thedomestic economy, for
example the decisions of utility businesses providing electricity
or gas or water on their tariffs for the year ahead, or the pricing
strategies of the food retailers based on the strength of demand
and competitive pressure in their markets.
A rise in the rate of VAT would also be a cause of increased
domestic inflation in the short term because it increases a firms
production costs.
Inflation can also come fromexternal sources, for example a
sustained rise in the price of crude oil or other imported
commodities, foodstuffs and beverages.
Fluctuations in the exchange ratecan also affect inflation for
example a fall in the value of the pound against other currencies
might causehigher import pricesfor items such as foodstuffs from
Western Europe or technology supplies from the United States which
feeds through directly or indirectly into the consumer price
index.
Demand-Pull Inflation
Demand pull inflation occurs when aggregate demand is growing at
an unsustainable rate leading toincreased pressure on scarce
resourcesand apositive output gap
When there isexcess demand, producers are able to raise their
prices and achieve biggerprofit marginsbecause demand is running
ahead of supply
Demand-pull inflation becomes a threat when an economy has
experienced a boom withGDPrising faster than the long-run trend
growth of potential GDP
Demand-pull inflation is likely when there isfull employment of
resourcesand SRAS is inelastic
Main Causes of Demand-Pull Inflation
Adepreciationof the exchange rateincreases the price of imports
and reduces the foreign price of a countrys exports. If consumers
buy fewer imports, while exports grow, AD in will rise and there
may be amultiplier effecton the level of demand and output
Higher demand from afiscal stimuluse.g. lower direct or indirect
taxes or higher government spending. If direct taxes are reduced,
consumers have more disposable income causing demand to rise.
Higher government spending and increased borrowing creates extra
demand in the circular flow
Monetary stimulus to the economy:A fall in interest rates may
stimulate too much demand for example in raising demand for loans
or in leading to house price inflation. Monetarist economists
believe that inflation is caused by too much money chasing too few
goods and that governments can lose control of inflation if they
allow the financial system to expand the money supply too
quickly.
Fast growth in other countries providing a boost to UK exports
overseas. Export sales provide an extra flow of income and spending
into the UK circular flow so what is happening to the economic
cycles of other countries definitely affects the UK
Cost-Push Inflation
Cost-push inflation occurs when firms respond torising costs, by
increasing prices toprotect their profit margins.
There are many reasons why costs might rise:
Component costs:e.g. an increase in the prices of raw materials
and other components. This might be because of a rise in commodity
prices such as oil, copper and agricultural products used in food
processing. A recent example has been a surge in the world price of
wheat.
Rising labour costs- caused by wage increases, which are greater
than improvements in productivity. Wage costs often rise when
unemployment is low because skilled workers become scarce and this
can drive pay levels higher. Wages might increase when peopleexpect
higher inflationso they ask for more pay in order to protect their
real incomes. Trade unions may use their bargaining power to bid
for and achieve increasing wages, this could be a cause of
cost-push inflation
Expectationsof inflationare important in shaping what actually
happens to inflation. When people see prices are rising for
everyday items they get concerned about the effects of inflation on
their real standard of living. One of the dangers of a pick-up in
inflation is what theBank of Englandcalls second-round effects i.e.
an initial rise in prices triggers a burst of higher pay claims as
workers look to protect their way of life. This is also known as a
wage-price effect
Higher indirect taxes for example a rise in the duty on alcohol,
fuels and cigarettes, or a rise in Value Added Tax. Depending on
the price elasticity of demand and supply for their products,
suppliers may choose to pass on the burden of the tax onto
consumers.
A fall in the exchange rate this can cause cost push inflation
because it leads to an increase in the prices of imported products
such as essential raw materials, components and finished
products
Monopoly employers/profit-push inflation where dominants firms
in a market use their market power (at whatever level of demand) to
increase prices well above costs
Cost-push inflation such as that caused by a large and
persistent rise in the world price of crude oil can be shown in a
diagram by aninward shift of the short run aggregate supply curve.
The fall in SRAS leads to a contraction of national output together
with a rise in the level of prices. This is shown in the next
diagram.
What are some of the main consequences of inflation?
"The lesson of the past fifty years is that, when inflation
becomes embedded, the cost of getting it back down again is a
prolonged period of sluggish output and high unemployment. Price
stability returning inflation to the target is a precondition for
sustained growth."Source: Mervyn King, Governor of the Bank of
England, Mansion House speech, June 2008
Many government s have atarget for a low but positive rate of
inflation. They believe that persistently high inflation can have
damaging economic and social consequences.
Income redistribution: One risk of higher inflation is that it
has aregressive effecton lower-income families and older people in
society. This happen when prices for food and domestic utilities
such as water and heating rises at a rapid rate.
Falling real incomes: With millions of people facing a cut in
their wages or at best a pay freeze, rising inflation leads to a
fall in real incomes.
Negative real interest rates: If interest rates on savings
accounts are lower than inflation, people who rely on interest from
their savings will be poorer. Real interest rates for millions of
savers have been negative for at least four years
Cost of borrowing: High inflation may also lead to higher
interest rates for businesses and people needing loans and
mortgages as financial markets protect themselves against rising
prices and increase the cost of borrowing on short and longer-term
debt. There is also pressure on the government to increase the
value of the state pension and unemployment benefits and other
welfare payments as the cost of living climbs higher.
Risks of wage inflation: High inflation can lead to an increase
in pay claims as people look to protect their real incomes. This
can lead to a rise in unit labour costs and lower profits for
businesses
Business competitiveness:If one country has a much higher rate
of inflation than others for a considerable period of time, this
will make its exports less price competitive in world markets.
Eventually this may show through in reduced export orders, lower
profits and fewer jobs, and also in a worsening of a countrys trade
balance. A fall in exports can trigger negative multiplier and
accelerator effects on national income and employment.
Business uncertainty: High and volatile inflation is not good
for business confidence partly because they cannot be sure of what
their costs and prices are likely to be. This uncertainty might
lead to a lower level of capital investment spending.
High and volatile inflation can have serious economic and social
consequences summarized below
Why is the rate of inflation difficult to forecast
accurately?
The rate of inflation is one of the most important macroeconomic
indicators that we study in macroeconomics. Data on prices is
published regularly and given lots of attention by the media and
the financial markets. Many agents be they businesses, households
and governments would like to have accurate forecasts of what is
likely to happen to prices in the future because they affect
spending, saving and investment decisions.
Inflation is a difficult indicator to forecast accurately. Our
chart below shows the UK CPI inflation forecast published by the
Bank of England in their quarterly Inflation Report. Remember that
the Bank of England has a mandate to control the rate of inflation
so that CPI inflation remains close to the 2% target. The
probability fan chart for inflation indicates the range of
probabilities for inflation in the forecast period. Notice how wide
is that range, there is much uncertainty about what is likely to
happen to inflation in the UK. In 2014, there is the possibility of
deflation (inflation of -1%) or inflation higher than 4%. The
darker the shading, the higher the probability attached to the
outcome.
Some reasons for difficulties in forecasting inflation
The Banks Inflation TargetIn order to maintain price stability,
the Government has set the Banks Monetary PolicyCommittee (MPC) a
target for the annual inflation rate of the Consumer Prices Index
of 2%. Subject to that, the MPC is also required to support the
Governments objective of maintaining high and stable growth and
employmentControlling inflation macroeconomic policies
Inflation can be reduced by policies that (i) slow down the
growth of AD or (ii) boost the rate of growth of aggregate supply
(AS)
Fiscal policy:
a. Controlling aggregate demand is important if inflation is to
be controlled. If the government believes that AD is too high, it
may choose to tighten fiscal policy by reducing its own spending on
public and merit goods or welfare payments
b. It can choose to raise direct taxes, leading to a reduction
in real disposable income
c. The consequence may be that demand and output are lower which
has a negative effect on jobs and real economic growth in the
short-term
Monetary policy:
a. A tightening of monetary policyinvolves the central bank
introducing a period of higher interest rates to reduce consumer
and investment spending
b. Higher interest rates may cause theexchange rateto appreciate
in value bringing about a fall in the cost of imported goods and
services and also a fall in demand for exports (X)
Supply side economic policies:
a. Supply side policies seek to
increaseproductivity,competitionandinnovation all of which can
maintain lower prices. These are ways of controlling inflation in
the medium term
A reduction in company taxes to encourage greater investment
A reduction in taxes which increases risk-taking and incentives
to work a cut in income taxes can be considered both a fiscal and a
supply-side policy
Policies to open a market to more competition to increase supply
and lower prices
b. Rising productivity will cause an outward shift of aggregate
supply
4. Direct controls - a government might choose to introduce
direct controls on some prices and wages
b. Public sector pay awards the annual increase in government
sector pay might be tightly controlled or even froze (this means a
real wage decrease).
c. The prices of some utilities such as water bills are subject
to regulatory control if the price capping regime changes, this can
have a short-term effect on the rate of inflation
Evaluation points how best can inflation be controlled?
The most appropriate way to control inflation in the short term
is for the government and the central bank to keep control of
aggregate demand to a level consistent with our productive
capacity
AD is probably better controlled through the use of monetary
policy rather than an over-reliance on using fiscal policy as an
instrument ofdemand-management
Controlling demand to limit inflation is likely to be
ineffective in the short run if the main causes are due to external
shocks such as high world food and energy prices
The UK is an open economy in which inflation is strongly
affected by events in the rest of the world
In the long run, it is the growth of a
countryssupply-sideproductive potential that gives an economy the
flexibility to grow without suffering from acceleration in cost and
price inflation.
UNIT 2
Prepared By: A.LavanyaPage 13