Government and Political influence Flashcards
How does the government use interest rates
in the UK interest rates are set by
the Monetary Policy Committee of the Bank of England, but this is not the case in all countries. Even in the UK, political influences impact on the rate of interest – for example the Bank of England is tasked by the government with ensuring that the rate of inflation stays within certain parameters.
Although they ultimately set the rate of interest, the rate they set will be mindful of this objective. In addition, members of the monetary policy committee are chosen by the government.
A recent example of this can be seen in June 2022 when the MPC started making gradual but significant increases to interest rates to try and bring inflation under control – the target rate of 2% inflation may be
two years away.
The maximum effect of a change in interest rates is usually felt 18-24 months after the change is made.
what is government political bias?
Historically, governments seeking to be re-elected have given what might be called ‘sweeteners’ to voters, perhaps tax cuts, leading to feelings of wealth but also to overheating in the economy.
If we have more money in our pockets, this makes us want to buy more. If supply doesn’t increase at the same pace as demand, then prices will rise as demand outstrips supply. This is then addressed by either the new government after the election or the same government, but now with a further term ahead of them! They raise taxes or cut benefits so that
people have less money to spend… this reduces demand and brings prices back under control. This has contributed to the cyclical nature of the economy.
Equally, the government is a major spender which pumps money into the economy. Both spending and taxes are significant factors in the economic cycle.
how can we stimulate growth when interest rates are low?
In relatively recent times, when interest rates were near to zero, the capacity
for the Bank of England to cut rates and stimulate the economy has been reduced. In these circumstances, the government has attempted to stimulate growth by effectively printing money – having the Bank of England buy government stock through quantitative easing.
What happened in the 1990’s during the dot com bubble?
The so called ‘dotcom’ bubble in the late 1990s saw investors buying into what seemed like any company involved inntechnology, often at massively over-inflated prices. When the bubble eventually burst, the impact on investors was massive.
Likewise, until the credit crisis in 2007, Financial Services had been very popular with investors. When the bottom fell out of this market the repercussions were significant. At the time of writing, significant investment is moving into renewable energy and also into virtual reality and augmented reality technology. It remains to be seen what the long term prospects are in these markets
What are financial bubbles and the greater fools theory?
There have been many occasions over the years where assets prices have been inflated to ridiculous levels as a result of investors forgetting the principles of sound investment theory (e.g looking at the fundamentals of a company) and buying shares based on the fact that they think it is going to be the next best thing and that the share price will continue to rise.
The theory that underpins this, is known as the “greater fools theory”, basically you always expect someone (a grater fool than you) to purchase the shares at a higher price and hence add to the upward trend, backed by no substance or sound financial reasoning. This causes an upward spiral and can be very dangerous as prices can only rise so much before the whole thing “pops”, otherwise known as a crash. Classic examples are the dotcom bubble of the late nineties, early 2000’s and much more recently cryptocurrency, where bitcoin has experienced numerous rises in value followed by sharp crashes since 2010. This could easily be considered a bubble.
How often do we experience a boom (financial bubble) in the economic cycle ?
Research suggests that we experience a boom every decade for the last 60 years with each bull market lasting roughly 10
years (e.g. 90’s – Technology and Media, 2000’s – Banking, 2010’s – Technology).
At the end of this period the economy slows down and crashes, which means going into the next decade, central banks have to react and typically lower interest rates (a form
of loose monetary policy and often referred to as an interest rate-driven cycle) to help stimulate the economy, which in turn starts the next boom! In these periods investors tend to direct money into specific sectors that they feel could do well and hence create speculation and another potential bubble, increasing values towards the end of the period, potentially causing another crash and then the whole thing starts again.
How can the ageing population have an impact on the economy?
Factors like the ageing population in the UK and the rest of the western world can impact on the needs of the economy – for example in terms of the need to keep inflation low, so as not to erode peoples hard earned savings. The increase in life expectancy means on average people will have longer retirements, which means that they need to save more to fund it. This ultimately increases household wealth which in turn tends to increase demand for services (banking, insurance etc). This increased level of savings and investment has a direct impact on global financial markets (as this is where funds are typically invested). At the time of writing investors in the US have a greater percentage of assets in funds than they hold in cash deposits.
The greater the percentage of retirees on fixed incomes, the more significant inflation becomes. The increase in the number of people over the age of 65 also increases the
demand on the state as a greater number of people become eligible for state benefits including the state pension (in general). This is something that the government needs to
address..
How can international nations have an impact on the economy?
International relations can have a
significant impact on the economy in general, as a result of globalisation and the fact that we live in a much more connected world resulting in an increase in correlation between financial markets in different countries. This can create issues when deciding where to allocate your funds.
Major terrorist attacks like 9/11 and the COVID 19 pandemic had a profound impact on the performance of global markets with shares on all major markets falling significantly in value. Equally, the UK vote to exit the European Union is a classic example of how political decisions can affect interest rates and the value of currency. As result of BREXIT, the pound reduced in value significantly. To combat this, the Bank of England reduced the base rate to as low as 0.1% and increased quantitative easing (buying government and corporate bonds, introducing money into the system) to £895bn which equated to 40% of annual GDP! Uncertainty in one nation is increasingly leading to concern and falling markets in other countries as the world becomes more and more connected. Consider, for instance, the major companies in the UK. Most of them are global companies and many are actually foreign owned.
