Topic 2 - Economic Policy and Financial Regulation Flashcards
2.1 - What are the key macroeconomic adjectives?
4 key macroeconomic objectives:
- Price stability
- Low employment
- Balance of payments equilibrium
- Satisfactory economic growth
2.1. - What are the key macroeconomic adjectives? (cont.)
These objectives fall into 2 pairs:
- Policies to reduce unemployment will also boost growth.
- Measures to reduce inflation will also help improve the balance of payments
2.1. (cont.) Key terms
Inflation - Increase in general level of prices and goods, resulting from “too much money chasing too few goods.” Basically the rate of growth of money supply is greater than the rate of growth of real goods and services
Disinflation - A fall in the rate of inflation - prices are still rising but slower than before
Deflation - A fall in the price of goods and services, i.e. the inflation rate is below 0% - a negative inflation rate
Recession - Significant decline in economic activity over a sustained period. 2 consecutive quarters of negative economic growth as measured by GDP.
GDP - Measure of a country’s overall economic activity. Its the monetary value of all the goods and services produced within the count during a given period, e.g. a year
2.1. (cont.) 4 main phases of economies
The 4 main phases of economies are:
1) Recovery and expansion
- Interest rates, inflation and unemployment are low
- Consumers have money to spend
- Demand for goods and services rise - pushing prices up
- Share prices improve as businesses flourish
2) Boom
- To prevent the economy from overheating, BoE may put up interest rates to control consumer spending and dampen inflation
3) Contraction or slowdown
- Once the effects of interest rate rises are felt:
- Demand for goods and services fall
- Profits (and share prices) fall
- Unemployment rises
- Inflation slows down
4) Recession
- As economy head to lowest level of economic activity, BoE may intervene to reduce interest rates in order to stimulate demand and set economy on path back to recovery
2.1. (cont.) 4 main phases of economies
This approach to the economy is described as “stop-go”. Was prevalent from 1960s to 1990s.
Since 90s - approach has been to keep inflation steady at a low rate.
Objective is to keep inflation at an annual rate of 2% with a 1% divergence on either side (1-3% target)
2 major types of policy used by governments:
- Monetary policy
- Fiscal policy
2.2. Monetary Policy
– Monetary experts believe inflation is caused by an increase in the money supply
- Increase in money supply caused by increase in amount of credit created by banks
- For government to control the growth of money supply they must control the amount of credit banks create
- Common way to do this is by manipulating interest rates
- Other methods include imposing restrictions on amounts banks can lend
- Or borrowers can be required to provide a minimum cash deposit when borrowing to make a deposit
- These last 2 are currently no used in the UK
- Manipulation of interest rates is the favoured method
- Monetary Policy Committee (MPC) of the BoE decides on interest rate BoE will lend to banks and financial institutions
- This official rate (known as the Bank Rate) determines all other interest rates charged to borrowers or paid to lenders
- BoE acts independently of the government
- However the Treasury retains the right to give instructions to BoE regarding monetary policy in “extreme economic circumstances.”
2.2. Monetary Policy (cont.) - terms
Bank rate - Rate at which BoE lends to other financial institutions
- Also known as “base rate”
Inflation target - Level of inflation economists say is needed to keep the national economy functioning efficiently. In the UK the target is 2% as measured by the CPI (1% maximum divergence either way)
MPC and interest rates - usually meet 8 times a year over 3 days to set interest rate
- Bank publishes inflation target report every year - provides analysis of UK economy and factors influencing policy decisions
2.2.1. Impact of interest rate changes
- If MPC changes interest rate, banks etc. tend to follow suit and alter their rates by something close to the same amount
- Banks apply margin between the rate at which they borrow money and the rate at which it lends money out - to cover costs and generate profit
- This means banks rates are variable because they follow the BoE rate.
- Since 2007-2009 financial crisis banks haven’t followed the base rate as closely as they used to
- Base rate was maintained at 0.5% between 2009 and 2016
- Cut further to 0.25% in August 2016
- Interest rates have since increased gradually at first but rising to 3.5% in Dec 2022 to combat “cost of living crisis”
- As rate was still relatively low it was hard for lenders to make profits on lending without setting rates at a higher margin than BoE
- Until relatively recently, most loan interest rates (including mortgages) were variable rates
- But with variable rates it was difficult for borrowers to budget for the future - especially if the rates rose
- With development of wholesale money market - lenders can obtain large amounts of money at fixed rates which they can lend to the borrower
- Disadvantages of fixed rate mortgages are that if variable rates falls borrower could still be fixed at a higher rate
- ERC’s for paying off the mortgage early within the fixed-rate period
2.3. Fiscal Policy
- Sometimes called budgetary policy
- Involves influencing the money supply by manipulating the finances of the public sector
- Public sector is responsible for services such as education, healthcare and transport
- To pay for these services government needs to raise funds from the private sector from direct and indirect taxes
- Direct taxes - from individuals and their assets (income tax, CGT, inheritance tax, national insurance)
- Indirect taxes - Applied to goods and services when they’re purchased (VAT and stamp duty)
2.3. Fiscal Policy (cont.1)
3 general outcomes for how economy is affected by fiscal policy:
1) Balanced budget - amount in tax taken = government spending
2) Budget surplus - Tax taken is greater than public spending - economy contracts
3) Budget deficit - Public spending is greater than tax taken - economy expands
2.3. Fiscal Policy (cont.) The Budget
The Budget
- Budget statement by chancellor made to House of Commons outlines economy state and proposals for changes to taxation
- House debates the Budget and the subsequent Finance Bill which enacts the Chancellor’s proposals
- Budget also includes forecasts that are provided by the Office for Budget Responsibility (OBR)
2.3. Fiscal Policy (cont.) Using taxation to control inflation
Increase in taxation > Less disposable income > Less spending > less demand for goods and services > inflation falls
Reduction in taxation > more disposable income > more spending > more demand for goods and services > inflation rises
2.3. Fiscal Policy (cont.) Using taxation to control inflation
- Fiscal policy has microeconomic benefits too
- Can be targeted on particular areas of the economy
- Example of this is tax incentives to manufacturing industries to boost employment in a declining sector
- Or government grants given to firms to move to particular areas to boost the local economy
2.3. Fiscal Policy (cont.) Changes in taxation affect the market for financial services and products in 2 main ways
1 - Increased general taxation reduces amount of money available for investment or to fund loan repayments
2 - Tightening of taxation regime in relation to particular products makes them less attractive to investors
