managing the national economy

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Managing The National Economy



C ontent

� 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 interms of another

� Money supply ± the amount of money incirculation 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 fromthe supply side instead they control interest rates asthey believe these will control the demand for money inthe economy

� The committee take a gradualist approach to monetary

policy ± they believe that by moving interest rates insmall steps they can achieve their aims and not createconsumer hysteria at the rises

� The Bank sets the rate of interest after analysingmacroeconomic 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 inthe economy (at a level of 1.5-3.5% - target =2.5%)

� If the Bank believes the level of AD is rising tooquickly potentially causing cost push inflationthey will decide to raise interest rates



W hat does the bank consider when

setting interest rates? � The bank looks at the following factors:± Economic growth and capacity utilisation

± Unemployment

± C onsumer borrowing

± Inflation

± C onsumer and business confidence

± Trends in exchange rates± International economic data

± Future predictions



Transmission Mechanism

� W hen the Bank Of England changes interest rates it takes time for the effects to be transmitted to theeconomy

� The new interest rate is transmitted to consumersthrough market interest rates which influence the cost of credit and borrowing, price of assets, expectationsand exchange rates

� These in turn transmit the information through their influence on aggregate demand which can lead to aninflationary / deflationary response



Interest Rates and The Economy

� C hanges to interest rates influence many thingsin the economy:

± Housing prices and housing market ± if interest rates rise the cost of mortgages increases thereforereducing 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 homeowners falls as they have larger mortgage payments(variable rate only)



Interest Rates and The Economy

� Investment ± if interest rates rise they lead to adecrease in the level of investment

� Exchange rates ± An increase in interest ratesmay lead to an appreciation of UK currency making exports less attractive



Interest rates and credit demand

� C redit demand ± if interest rates rise the amount of credit sales should decrease as it becomesmore expensive

� If credit is more expensive consumers monthly payments will increase on existing debts whichmeans 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 thegovernments economic objective

� The main objective of monetary policy is stableprices or the control of inflation

� The UK government have been able to achieveinflation within the target zone by allowing thebank 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

� C hanges to the exchange rate can influence thepolicy 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 growthtends 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 importsand exports

� If the value of the £ is higher it means imports are

relatively cheap and therefore the demand for themincreases

� A high value £ also means that exports will be moreexpensive 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

� C hanges in the UK¶s interest rates will lead to changesin the exchange value of the pound.

� If interest rates rise the value of the pound will rise sothe pound will now buy more US dollars, JapaneseYen, 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 thecurrency is determined by its supply and demand

± Managed floating exchange rates ± There may besome 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 exchangerates

� Fully fixed exchange rates ± The exchange rateis pegged at a certain point



Exchange rate control

� Some countries use exchange rate control as away of influencing their economy

� If exchange rates are fixed competitiveness canbe increased as they are able to reduce costs inthe knowledge that their exchange rate will stay constant



UK Exchange Rate

� The UK has a free floating exchange rate so theprice of the £ is influenced by the interaction of supply and demand

� The UK has had a free floating exchange ratesince 1992



W hat 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:

� C ontractionary fiscal policy:W here the government reducespending and / or when they make taxes higher, they try toincrease its PSBR( public sector borrowing requirement) to fund the tax drops they also do this to reduce its surplus on itsbudget for the fiscal year.

� Expansionary fiscal policy:W here the government cut taxes or increase government spending. They will increase the amount the government borrows to fund the expenditure.



G overnment expenditure

� G overnment expenditure covers all spending by thepublic 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 (valueadded tax), changes in this type of tax has arapid 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 systemare:

± 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 asthey can be regressive resulting in a loss of equity

� May cause cost-push inflation if they are toohigh

� In periods of recessions revenue levels areuncertain

� They are not transparent



Direct taxes - Advantages

� Are relatively transparent

� Are equitable ± everyone pays the same

� C an 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

� C an act as a disincentive to work � C an 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 freebonus 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 theability 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 ashealthcare and education meet the costs of them



Budgetary Balance

� Budgetary balance is where government expenditure and taxation are equal

� If taxation does not meet expenditurerequirements then the government have toborrow money

� G ordon Brown has run the UK Economy at adeficit for the last few years causing concernamongst many that the borrowing cant besustained and that expenditure has been

wasteful



C hanges 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 educationor healthcare or lower than inflationary pay risesin these areas ( G ordon Brown did this in March2007)

� It can also influence the benefits system by making it more difficult or easier to claimbenefits



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 towork harder for the same money, if it decreasespeople have to work less hard for the samemoney

� Taxation and benefits can also create thepoverty trap which mean it is often not muchbetter 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 tohelp correct market failure and account for externalities encouraging consumption of merit goods and discouraging consumption of

demerit goods



Fiscal Policy

� C orporation and business taxes can influencethe 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 C hancellor of the Exchequer

� As monetary policy is now in the hands of thebank of England the chancellor now only dealswith 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 thegovernments policy objectives

� These are:± Stable prices

± Low unemployment

± Sustained economic growth

± Increase in living standards

± Sustainable balance of payments



C onflicts ± Low Unemployment and Low Inflation

� Low unemployment and Low inflation shown in thePhillips curve

� The Phillips curve states aninverse relationship betweeninflation and unemployment

� However from 1997 onwardsthe UK have enjoyed low

levels of unemployment and inflation



Healthy G rowth 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 areused which decrease levels of investment and consumption and therefore economic growth

� There is a level of trend growth where theeconomy grows but inflation doesn¶t occur ±this is seen as being 2.5-3.5%



Healthy G rowth And Balance of Payments Equilibrium

� W hen the economy grows rapidly consumptiontends to be high

� UK British consumers tend to prefer goods fromabroad therefore imports grow relative toexports

� This makes the balance of payments worsenand can cause or increase the deficit



Healthy G rowth And The

Environment � W hen the economy grows more rapidly production increases which increasesenvironmental pollution

� Some economists argue that as countriesbecome richer they are able to focus more onenvironmental objectives and use cleaner

technologies thereby reducing theenvironmental impact



Monetarists / Supply Side View

� Monetarists argue that the major macroeconomic objectives are compatible inthe long run

� In the UK from 1997 onwards there has beenrelatively 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 G ordon 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

managing the national economy

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