A-LEVEL

Economics
Government Fiscal Policy
Fiscal policy involves the use of government spending, taxation and
borrowing to affect the level and growth of aggregate demand, output and jobs
Fiscal policy is also used to change the pattern of spending on 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 affect aggregate demand (AD) and aggregate
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 an instrument of demand
management. This means that changes in government spending, direct and
indirect taxation and the budget balance can be usedcounter-cyclically to
help smooth out some of the volatility of national output particularly when the
economy has experienced an external shock and is in a recession.

The Keynesian school argues that fiscal policy can have powerful effects
on demand, output and employment when the economy is operating
below full capacity national output, and where there is a need to provide
a demand-stimulus.

Monetarist economists believe that government spending and tax

changes only have a temporary effect on aggregate demand, output and
jobs and that the tools of monetary policy are 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

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The multiplier effects of an expansionary fiscal policy depend 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 as interest rates
A contractionary fiscal policy would 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 are welfare payments made available through the social
security system including 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 a basic floor of
income or 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 on state-provided

goods & services that are provided on a recurrent basis - for example
salaries paid to people working in the NHS and resources for state

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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 belowthe data is taken from the March 2011 UK Budget Statement available from the
HM Treasury website. Social protection is 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 of public goods and merit goods and
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 a safety-net system of welfare benefits to supplement the

incomes of the poorest in society this is also part of the process of
redistributing income and wealth. Government spending has an
important role to play in controlling / reducing the level of relative poverty

To provide necessary infrastructure via capital spending on transport,

education and health facilities an important component of a countrys
long run aggregate supply

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Government spending can be used to manage the level and growth of
AD to 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 taxation is levied on income, wealth and profit. Direct taxes

include income tax, inheritance tax, national insurance contributions,
capital gains tax, and corporation tax.

Indirect taxes are 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 Tax

Tax Revenue in 201011

Income tax

153.3

National insurance contributions 97.7

Value added tax

86.3

Corporation tax

43.0

Fuel duties

27.3

Council tax

25.7

Business rates

23.3

Tobacco duties

9.1

Stamp duty land tax

6.0

Vehicle excise duties

5.8

Beer and cider duties

3.7

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Capital gains tax

3.6

Source: Office for Budgetary Responsibility, March 2012

Progressive, proportional and regressive taxes and the distribution of
income

With a progressive 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 a proportional 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 a regressive 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 Tax
Income tax in the UK is progressive 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 Tax
This is a tax on business profits. There is a tax free allowance for businesses
making low annual profits
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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 policy

Discretionary fiscal changes are deliberate changes in direct and indirect
taxation and govt spending for example, increased capital spending on roads or
more resources going into the NHS.
Automatic stabilisers are 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
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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 larger budget deficit.
Fiscal Policy and Aggregate Supply
It is important to understand that fiscal policy can have important effects on
the supply-side of the economy. Indeed many government fiscal decisions are
made with improving the supply-side in mind.
The current Coalition government has launched a Growth 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 that welfare benefit reforms are 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 on infrastructure (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:

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a. Government spending can be used to fund an expansion in new
small business start-ups

Research and development and innovation:

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 capital of 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 Agenda

Free market economists are 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 a budget 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

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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 large budget deficit can 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 a debt
trap where 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 an opportunity cost involved 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%

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saved on 220bn of new debt pays one years salary for 46,000
teachers.
c. Higher public sector debt also represents a transfer of
income from 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-out is 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 deficit

1. 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
the stock of national assets
b. For example, spending on transport infrastructure improves
the supply-side capacity and productivity of the economy
c. 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
managing aggregate demand
b. An increase in borrowing can be a useful stimulus to
demand when other sectors of the economy are suffering from
weak or falling spending

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c. A change in the government budget deficit may lead to a more than
proportional change in aggregate demand this is known as
the fiscal 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 of fiscal austerity amounting 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 economists argue that deficit-reduction policies risk driving

the economy into a second recession known as a double-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+XM). 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

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Monetary Policy

Monetary policy influences 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:

A medium of exchange used in payment for goods and services

A unit of account used to relative measure prices and draw up accounts

A standard of deferred payment for example when using credit to purchase goods and
services now but pay for them later

A store 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 between savings rates and borrowing rates, interest rates on secured and
unsecured loans and short term and long term interest rates on different forms of savings account.

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However we find that interest rates tend to move in the same direction. For example if the Bank 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

The real rate of interest is 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

The Bank of England has 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
the UK economy consistent with the need to meet an inflation target set by the government

That inflation target is consumer price inflation of 2%

The MPC has one eye on maintaining growth (although a set rate of GDP growth is not part
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

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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 spare capacity: The rate of growth of GDP and the size of the output 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) and house 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 of house price inflation but it has been criticized
for not doing enough to prevent the housing bubble in Britain up to 2008.
Consumer confidence and 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 costpush 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 about inflationary pressures over
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!

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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 the ceteris paribus assumption (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 the transmission 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 the lending and borrowing rates charged 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 on confidence 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 household wealth and put a squeeze on equity

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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.

Business capital 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 dampen confidence and 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 the exchange rate:

a. The link between interest rates and movements in the external value of a currency are
important to understand at AS level.

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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 money into the British banking system.
c. A stronger exchange rate reduces the competitiveness of UK exports in 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 the trade deficit in 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
where demand is interest elastic in other words, demand responds elastically to a change in
interest rates or indirectly through changes in the exchange rate

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Good examples of interest-sensitive industries include 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 as oil 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 crunch was 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 the Bank of
England had 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

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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

the competitiveness of the export sector

Lower rates are designed to boost consumer and business confidence

But 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.

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In March 2009 the Bank of England started a policy of quantitative 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 the supply 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 this unconventional strategy, the MPC discusses each month how many assets,
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 lags should 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

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accuracy the extent to which a change in interest rates will achieved the desired / planned
economic effects

When it comes to inflation targeting there are many factors affecting costs and prices and
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 policy does 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 the distribution of income and
wealth in 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:

o

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:

o

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:

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o

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 a re-distribution of income away 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 an active 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 deeprooted 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

The Claimant Count measure 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.

The Labour Force Survey counts 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
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500,000 in recent years. Because it is a survey - 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 a sampling 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

are discouraged workers who have been out of work for a long time and who have stopped
applying for jobs

2 / economically inactive people who are not 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 of under-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?

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Types and Causes of Unemployment

Frictional Unemployment
Frictional unemployment is transitional unemployment as 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 information in the labour market may make frictional unemployment worse if the
jobless are unaware of the available jobs.

Incentives problems can 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 are disincentives for people to accept work, this is known as the unemployment
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 of unfilled
vacancies in the UK. For most of the current decade there have been between 500,000 and 700,000
unfilled vacancies.
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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 a long-term decline in demand in an industry leading
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 a mismatch between their skills and the requirements
of the new job opportunities. This problem is due to occupational 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.
Globalisation inevitably leads to changes in the patterns of trade between countries. Britain has
probably now lost a cost advantage in manufacturing goods 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.

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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 is involuntary unemployment due to a lack of demand for goods and services.
This is also known as Keynesian unemployment or demand-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 rising productivity. 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.

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Inflation

Inflation is a sustained increase in the cost of living or the average / general price
level leading to a fall in the purchasing 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?

The rate of inflation is measured by the annual percentage change in consumer prices.

The British government has set an inflation target of 2% using the consumer price index (CPI)

It is the job of the Bank of England to 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 avoid price deflation we return to this
a little later.

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Falling inflation does not mean falling prices!

Please remember that a fall in the rate of inflation is not the same thing as a fall 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?

The cost of living is 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, the Retail Price Index (RPI) & the Consumer 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 a weighted 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

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The CPI is not fully representative:
o

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 audiovisual equipment is so different from its predecessors. In this respect, the CPI may overestimate 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 deflation happens when the rate of inflation becomes negative. I.e. the general price
level is falling and the purchasing power of say 1,000 in cash is increasing

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Some countries have experienced periods of deflation in recent years; perhaps the most wellknown example was Japan during the late 1990s and in the current decade. In Japan, the root
cause of deflation was slow growth and a high level of spare capacity that was driving prices
lower.
Hyperinflation

Hyperinflation is extremely rare. Recent examples include

Yugoslavia Argentina , Brazil , Georgia andTurkey (where inflation reached 70% in 1999)

The classic example of hyperinflation was the rampant 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 a store of value and also as a medium of exchange

The recent hyperinflation in Zimbabwe is 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 the mid to late 1970s when
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 of stagflation.
Understanding the main causes of inflation

Inflation can come from both the demand and the supply-side of an economy

Inflation can arise from internal and external events

Some inflationary pressures direct from the domestic 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 from external sources, for example a sustained rise in the price of crude oil or
other imported commodities, foodstuffs and beverages.
Fluctuations in the exchange rate can also affect inflation for example a fall in the value of the
pound against other currencies might cause higher import prices for 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

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Demand pull inflation occurs when aggregate demand is growing at an unsustainable rate
leading toincreased pressure on scarce resources and a positive output gap

When there is excess demand, producers are able to raise their prices and achieve
bigger profit margins because demand is running ahead of supply

Demand-pull inflation becomes a threat when an economy has experienced a boom

with GDP rising faster than the long-run trend growth of potential GDP

Demand-pull inflation is likely when there is full employment of resources and SRAS is
inelastic

Main Causes of Demand-Pull Inflation

A depreciation of the exchange rate increases 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 a multiplier effect on the level of demand and output

Higher demand from a fiscal stimulus e.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 to rising costs, by increasing prices to protect their
profit margins.
There are many reasons why costs might rise:
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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 people expect
higher inflation so 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

Expectations of inflation are 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
the Bank of England calls 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 an inward 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.

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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 a target 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 a regressive effect on lowerincome 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

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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

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The Banks Inflation Target

In order to maintain price stability, the Government has set the Banks Monetary Policy
Committee (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 employment
Controlling 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 policy involves the central bank introducing a period of
higher interest rates to reduce consumer and investment spending
b. Higher interest rates may cause the exchange rate to 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:

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a. Supply side policies seek to increase productivity, competition and innovation 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 overreliance on using fiscal policy as an instrument of demand-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 countrys supply-side productive potential that gives an
economy the flexibility to grow without suffering from acceleration in cost and price
inflation.

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