Managing The National Economy

Content
• Monetary policy, Money supply and interest rates
• The exchange rate as a target and instrument of
economic policy
• Taxation and public expenditure
• Fiscal policy
• The interrelationships between fiscal and monetary
policy
• Possible conflicts of policy objectives
 Monetary Policy
• Monetary policy is the use of interest rates, money
supply and exchange rates to influence economic
growth and inflation
• Interest rates – are the cost of borrowing money
• Exchange rates – the value of one currency in
terms of another
• Money supply – the amount of money in circulation
in an economy
 Monetary policy and the Bank of England
• The monetary policy committee at the Bank of England are
able to influence the money supply and set interest rates
• The Bank of England do not control money supply from the
supply side instead they control interest rates as they
believe these will control the demand for money in the
economy
• The committee take a gradualist approach to monetary
policy – they believe that by moving interest rates in small
steps they can achieve their aims and not create consumer
hysteria at the rises
• The Bank sets the rate of interest after analysing
macroeconomic trends and risks associated with inflation
Monetary Policy and The Bank Of England
• The Bank of England is independent from
government control
• Since 1997 the UK government has used interest
rates to control the level of inflation in the economy
(at a level of 1.5-3.5% - target = 2.5%)
• If the Bank believes the level of AD is rising too
quickly potentially causing cost push inflation they
will decide to raise interest rates
What does the bank consider when setting
interest rates?
• The bank looks at the following factors:
– Economic growth and capacity utilisation
– Unemployment
– Consumer borrowing
– Inflation
– Consumer and business confidence
– Trends in exchange rates
– International economic data
– Future predictions
 Transmission Mechanism
• When the Bank Of England changes interest rates it takes
time for the effects to be transmitted to the economy
• The new interest rate is transmitted to consumers through
market interest rates which influence the cost of credit and
borrowing, price of assets, expectations and exchange
rates
• These in turn transmit the information through their
influence on aggregate demand which can lead to an
inflationary / deflationary response
 Interest Rates and The Economy
• Changes to interest rates influence many things in
the economy:
– Housing prices and housing market – if interest rates
rise the cost of mortgages increases therefore reducing
demand for housing in theory (this has not occurred
recently in the UK)
– Disposable income of house owners – if interest rates
rise the real disposable income of home owners falls as
they have larger mortgage payments (variable rate only)
 Interest Rates and The Economy
• Investment – if interest rates rise they lead to a
decrease in the level of investment
• Exchange rates – An increase in interest rates may
lead to an appreciation of UK currency making
exports less attractive
 Interest rates and credit demand
• Credit demand – if interest rates rise the amount of
credit sales should decrease as it becomes more
expensive
• If credit is more expensive consumers monthly
payments will increase on existing debts which
means they have less disposable income
• If credit is cheaper than more people will apply for it
and use it
 Objectives of Monetary Policy
• Monetary policy is used to achieve the governments
economic objective
• The main objective of monetary policy is stable
prices or the control of inflation
• The UK government have been able to achieve
inflation within the target zone by allowing the bank
of England to set interest rates
 The Exchange Rate As A Target and
Instrument of Economic Policy
• Exchange rates show the price of one currency in
terms of another
• Changes to the exchange rate can influence the
policy objectives of inflation, unemployment and the
balance of payments
 Exchange rates and Inflation
• Exchange rates influence inflation because:
– It impacts the price of imports
– It impacts the price of exports
– It changes the price of oil and other commodities – oil is
sold in $ so when the exchange rate of £ to $ changes
so does the price of oil
– It can influence wage bargaining power
 Exchange rates and unemployment
• If exchange rates appreciate economic growth
tends to be slower which reduces AD and therefore
unemployment can occur
 Exchange rates and the balance of
payments
• Exchange rates change the relative values of imports and
exports
• If the value of the £ is higher it means imports are relatively
cheap and therefore the demand for them increases
• A high value £ also means that exports will be more
expensive so demand for them decreases
• This can cause a balance of payments deficit
• If the value of the £ is lower then it means imports are more
expensive and exports are cheaper therefore it can result in
a balance of payments surplus
 Interest and Exchange Rates
• Changes in the UK’s interest rates will lead to changes in
the exchange value of the pound.
• If interest rates rise the value of the pound will rise so the
pound will now buy more US dollars, Japanese Yen, Euros
etc.
• If interest rates fall the value of the pound will fall so the
pound will now buy less US dollars, Japanese Yen, Euros
etc
 Types of Exchange Rate - Floating
• There are a number of different methods of
exchange rate systems:
– Free floating exchange rates – here the value of the
currency is determined by its supply and demand
– Managed floating exchange rates – There may be some
government / central bank intervention if there are large
movements or its deemed beneficial for economic policy
 Types of Exchange Rate - Fixed
• Semi-fixed exchange rates – currency movements
are allowed within set boundaries, interest rates are
used to control exchange rates
• Fully fixed exchange rates – The exchange rate is
pegged at a certain point
 Exchange rate control
• Some countries use exchange rate control as a way
of influencing their economy
• If exchange rates are fixed competitiveness can be
increased as they are able to reduce costs in the
knowledge that their exchange rate will stay
constant
 UK Exchange Rate
• The UK has a free floating exchange rate so the
price of the £ is influenced by the interaction of
supply and demand
• The UK has had a free floating exchange rate since
1992
 What is fiscal policy
• Fiscal policy looks at how government spend their money and how
they control their taxes.
• There are 2 types of fiscal policy:
• Contractionary fiscal policy: Where the government reduce spending
and / or when they make taxes higher, they try to increase its
PSBR( public sector borrowing requirement) to fund the tax drops
they also do this to reduce its surplus on its budget for the fiscal year.
• Expansionary fiscal policy: Where the government cut taxes or
increase government spending. They will increase the amount the
government borrows to fund the expenditure.
 Government expenditure
• Government expenditure covers all spending by the public
sector
• This includes transfer payments which are made from tax
payers and benefits recipients
• The government spends money on many things including:
– Education
– Defence
– Healthcare
– Infrastructure
– Police
 Types of taxation
• Direct taxes are taxes of income and expenditure
e.g. income tax, corporation tax (levied on company
profits).
• Indirect taxes are taxes such as VAT (value added
tax), changes in this type of tax has a rapid effect
on the level of economic activity. E.g. an increase in
VAT will cut consumption
 Taxation Objectives
• The main objectives of the UK taxation system are:
– Equitable taxes
– To use them to correct market failure
– To improve incentives to work
– To tax spending (indirect) rather than income (direct)
– To keep the tax burden as low as possible
 Indirect Taxes – Advantages
• They can be used to influence demand
• They can be used to correct for negative
externalities e.g. with cigarettes
• They have less impact on peoples incentive to work
• More flexible method
• They provide incentives to save
• They allow consumers choice
 Indirect Taxes - Disadvantages
• They can increase the inequalities in income as
they can be regressive resulting in a loss of equity
• May cause cost-push inflation if they are too high
• In periods of recessions revenue levels are
uncertain
• They are not transparent
 Direct taxes - Advantages
• Are relatively transparent
• Are equitable – everyone pays the same
• Can be used to redistribute wealth (it is argued that
the UK tax system doesn’t do this)
• Taxation is paid before consumers receive their
salary so they don’t have to worry about it
 Direct Taxes - Disadvantages
• May not be as progressive as they could be
• Levels of consumption don’t effect them
• Can act as a disincentive to work
• Can be exploited by high earners
• Not every one understands the system
 Flat rate tax
• The concept of one tax rate for all with a tax free
bonus is seen as an fair and transparent method of
taxation
• Those in favour say they reduce bureaucracy and
admin costs, increase incentives to work and save,
increase taxation for the government and increase
foreign investment
 Equity
• For a system to be equitable those that have the
ability to pay will do so
• It is equitable to have a tax free amount as it means
the lowest earners will not be penalised
• The benefit principal – this aims to ensure all that
will benefit from public services such as healthcare
and education meet the costs of them
 Budgetary Balance
• Budgetary balance is where government
expenditure and taxation are equal
• If taxation does not meet expenditure requirements
then the government have to borrow money
• Gordon Brown has run the UK Economy at a deficit
for the last few years causing concern amongst
many that the borrowing cant be sustained and that
expenditure has been wasteful
 Changes to Public Expenditure
• If the level of public expenditure in the economy
changes it impacts public services and their
provision – this may include cuts in education or
healthcare or lower than inflationary pay rises in
these areas (Gordon Brown did this in March 2007)
• It can also influence the benefits system by making
it more difficult or easier to claim benefits
Fiscal Policy and Microeconomic influences
• As well as impacting the macroeconomy fiscal
policy also has microeconomic impacts
• Taxation influences peoples incentives to work – if
taxation increases it means people have to work
harder for the same money, if it decreases people
have to work less hard for the same money
• Taxation and benefits can also create the poverty
trap which mean it is often not much better
financially for an individual to work
 Fiscal policy
• Fiscal policy can be used to influence demand –
this can be caused by changes to indirect taxes
• The government use taxation and subsidies to help
correct market failure and account for externalities
encouraging consumption of merit goods and
discouraging consumption of demerit goods
 Fiscal Policy
• Corporation and business taxes can influence the
level of capital investment – if they are lower this is
likely to stimulate investment levels
 Interrelationships Between Fiscal And
Monetary Policy
• These two policies used to be the responsibility of
the Chancellor of the Exchequer
• As monetary policy is now in the hands of the bank
of England the chancellor now only deals with fiscal
policy
• The Bank of England make decisions with a full
awareness of the governments fiscal stance
 Possible conflicts of policy objectives
• There may be conflicts between the governments
policy objectives
• These are:
– Stable prices
– Low unemployment
– Sustained economic growth
– Increase in living standards
– Sustainable balance of payments
 Conflicts – Low Unemployment and Low
Inflation
• Low unemployment and Low
inflation shown in the Phillips
curve
• The Phillips curve states an
inverse relationship between
inflation and unemployment
• However from 1997 onwards
the UK have enjoyed low levels
of unemployment and inflation
 Healthy Growth and Low Inflation
• If the economy grows too quickly than supply cant
keep up with the increase in demand and therefore
prices will start to rise
• To keep inflation low high interest rates are used
which decrease levels of investment and
consumption and therefore economic growth
• There is a level of trend growth where the economy
grows but inflation doesn’t occur – this is seen as
being 2.5-3.5%
Healthy Growth And Balance of Payments
Equilibrium
• When the economy grows rapidly consumption
tends to be high
• UK British consumers tend to prefer goods from
abroad therefore imports grow relative to exports
• This makes the balance of payments worsen and
can cause or increase the deficit
Healthy Growth And The Environment
• When the economy grows more rapidly production
increases which increases environmental pollution
• Some economists argue that as countries become
richer they are able to focus more on environmental
objectives and use cleaner technologies thereby
reducing the environmental impact
 Monetarists / Supply Side View
• Monetarists argue that the major macroeconomic
objectives are compatible in the long run
• In the UK from 1997 onwards there has been
relatively low unemployment and inflation and
sustained economic growth
 Summary
• Monetary policy includes the control of money supply and interest rates
• In the UK the bank of England is in charge of monetary policy and their main tool is
interest rates
• Exchange rates look at the value of one currency in terms of another
• Fixed exchange rates can be used by governments to create stability within an
economy
• Taxation is the way the government earns revenues
• Direct taxes are levied on wages and businesses
• There has been a growing budget deficit under Gordon Brown
• Fiscal and monetary policy used to both be the job of the chancellor now monetary
policy is the Bank Of England's job however it is still influenced by fiscal policies
• There are a number of potential conflicts between policy objectives e.g. between
low unemployment and low inflation