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Fiscal And Monetary Policy To Stimulate The Economy Economics Essay

The government uses both fiscal and monetary policy to stimulate the economy, to get the economy growing and also to slow the rate of growth down when it gets overheated. With fiscal policy the government influences the economy by changing how the government collects and spends money.

Monetary policy, the government uses to influence its economy. Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" low unemployment, low inflation (target of 2%), economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Bank of England" (Dudley W. Johnson, 1926).

The inflation target of 2% is expressed in terms of an annual rate of inflation based on the Consumer Prices Index (CPI). The remit is not to achieve the lowest possible inflation rate. Inflation below the target of 2% is judged to be just as bad as inflation above the target. The inflation target is therefore symmetrical. (Bank of England, 2011)

The Consumer Price Index annual inflation the Government’s target measure was 4.4 per cent in February, up from 4.0 per cent in January, its highest level since 2008, according to figures from the Office for National Statistics (2011).

The causes of the largest upward pressures to the change in Consumer Price Index inflation came from domestic heating costs, particularly gas where average bills rose by 0.4 per cent between January and February this year but fell by 2.8 per cent a year ago, a record fall for a January to February period. There were smaller upward effects from electricity, where prices rose this year but were unchanged in 2010, and domestic heating oil, where prices fell by less than a year ago.

Clothing and footwear, where prices overall, rose by 3.6 per cent following the January sales. This was a record January to February movement, and compared with a 2.0 per cent rise a year ago. The upward effect came from garments, particularly women’s outerwear.

Miscellaneous goods and services the upward contribution here was driven principally by financial services where charges were little changed between January and February this year compared with a 1.3 per cent fall a year ago. The main upward effects came from mortgage arrangement fees and foreign exchange charges

Recreation and culture where prices; overall, rose by 0.3 per cent this year but were little changed a year ago. There were small upward pressures from books and from games, toys and hobbies, particularly computer games, partially offset by a small downward pressure from digital cameras and camcorders.

The largest downward pressure to the change in Consumer Price Index inflation came from alcoholic beverages and tobacco where prices, overall, fell by 1.1 per cent compared with 0.4 per cent a year ago. The 1.1 per cent was a record monthly fall and follows the record monthly rise of 4.6 per cent between December 2010 and January 2011. The downward effect on the change in CPI inflation was driven by alcoholic beverages, particularly spirits

In the year to February, Retail Price Index annual inflation was 5.5 per cent, up from 5.1 per cent in January. The main factors affecting the Consumer Price Index also affected the Retail Price Index.

Retail Price Index excluding inflation the all items RPI excluding mortgage interest payments was also 5.5 per cent in February, up from 5.1 per cent in January.

As an internationally comparable measure of inflation, the Consumer Price Index shows that the UK inflation rate in January was above the provisional figure for the European Union. The UK rate was 4.0 per cent whereas the EU’s as a whole was 2.8 per cent.

The increases of inflation may place pressure on the Bank of England to raise interest rates. Last month, Bank of England governor Mervyn King said: “Inflation is likely to continue to pick up by between 4 per cent and 5 per cent over the next few months.” He said the rise reflects an increase in world commodity and energy prices and that as the effect of that wages; inflation will fall back in 2012. (Mervyn King, 2011)

The most appropriate way to control inflation in the short term is for the UK government and the Bank of England to keep control of aggregate demand to a level consistent with productive capacity. The consensus among economists is that aggregate demand is probably better controlled through the use of monetary policy rather than an over-reliance on using fiscal policy as an instrument of demand-management. But in the long run, it is the growth of a country’s supply-side productive potential that gives an economy the flexibility to grow without suffering from acceleration in cost and price inflation. (Charles Bean, 2011)

Monetary policy aims to influence the overall level of monetary demand in the economy so that it grows broadly in line with the economy's ability to produce goods and services. This stops output rising too quickly or slowly. Interest rates are increased to moderate demand and inflation and they are reduced to stimulate demand. If rates are set too low, this may encourage the build-up of inflationary pressure; if they are set too high, demand will be lower than necessary to control inflation.(Bank of England, 2002-2010)

Monetary policy operates by influencing the price at which money is lent, i.e. the cost of borrowing and the income from saving. The effects on demand. When interest rates are changed, demand can be affected in various ways. (Bank of England, 2002-2010)

Spending and saving decisions a change in the cost of borrowing affects spending decisions. Interest rates will affect the attractiveness of spending today relative to spending tomorrow. An increase in interest rates will make saving more attractive and borrowing less so. This will tend to reduce current spending, by both consumers and firms. That includes spending by consumers in the shops and spending by firms on new equipment, i.e. investment. Conversely, a reduction in interest rates will tend to increase spending by consumers and firms.

The UK government in 2010 the Chancellor George Osborne has unveiled the biggest UK spending cuts for decades, with welfare, councils and police budgets all hit. Which were somehow compared to the situation in Greece’s finances have "fallen into a vicious circle" after the ruling socialists announced drastic spending cuts to contain the debt crisis, the country's central bank said in its annual report. (Helena Smith, 2010)

The UK has less debt than Greece, has a stronger economy and as a result is not regarded by financial markets in the way Greece is. On top of a smaller debt burden, the UK is also much better placed to finance its borrowing. That's because not only does Greece have a higher level of debt, but it has more pressure to continually refinance that debt. UK has the flexibility of policy response point of view, unlike Greece; The UK has control of it own financial affairs, with it owns currency and a central bank that can set interest rates in the interests of the domestic economy. The Bank of England has cut interest rates to 0.5% and added a further £200bn into the economy through quantitative easing. Quite simply, Greece has not had and does not have these advantages. Compare this to the UK, where the UK is forecast by the organisation of economics cooperation and development to experience growth of 1.3% and 2.5% in 2010 and 2011 respectively. In Greece, the figures are -3.7% and -2.5%. The implication, of course, being that while the UK's deficit will start to fall as a result of increased tax revenues and reduced benefit expenditure as the economy expands, in Greece, the debt crisis is only set to deepen. The UK has not once defaulted on its debt – unlike Greece, who has defaulted five times over the last 200 years. (Rachel Reeves, 2010)

Cash flow a change in interest rates will affect consumers' and firms' cash flow, i.e. the amount of cash they have available. For savers, a rise in interest rates will increase the money received from interest-bearing bank and building society deposits. But it will also mean higher interest payments for people and firms with loans, debtors who are being charged variable interest rates (as opposed to fixed rates which do not change). These include many households with mortgages on their homes. These fluctuations in cash flow are likely to affect spending. Lower interest rates will have the opposite effects on savers and borrowers.

Asset prices, a change in interest rates affects the value of certain assets, such as house and share prices. Higher interest rates increase the return on savings in banks and building societies. This might encourage savers to invest less of their money in alternatives, such as property and company shares. Any fall in demand for these assets is likely to reduce their prices. This reduces the wealth of individuals holding these assets, which, in turn, might influence their willingness to spend. Again, lower interest rates have the opposite effect, i.e. they tend to increase asset prices.

Examples of the affected industry, House prices in the UK have recorded their first annual fall for 12 years, according to the Nationwide. Prices fell by 1.1% in April, the sixth monthly decline in a row, and were down 1% from the levels seen in April 2007. House price falls reflected a weakening market which had been hit by "poor affordability and tighter financial market conditions". (BBC News, 2008)

Exchange rates, a particular influence on prices comes through the exchange rate. A rise in interest rates relative to those in other countries will tend to result in an increase in the amount of funds flowing into the UK, as investors are attracted to the higher sterling rates of interest. This will tend to result in an appreciation of the exchange rate against other currencies. In practice, the exchange rate will be influenced both by expectations about future interest rates and any unexpected changes in interest rates. That is because if investors expect interest rates to rise, they may increase the amount they invest in a currency before interest rates actually rise. So there is never a simple relationship between changes in interest rates and exchange rates. (Bank of England, 2002-2010)

Monetary committee policy can achieve a level of 2% in inflation in the long run is by controlling demand over interest rate by having stabilization of

Demand has not been the case of rises inflation in the UK at the moment, it is one of the element can occur to add pressure to the inflation rises. Demand-pull inflation is likely when there is full employment of resources and aggregate demand is increasing at a time when short run aggregate supply (SRAS) is inelastic.

The main causes of demand-pull inflation is largely the result of the level of aggregate demand being allowed to grow too fast compared to what the supply-side capacity can meet. The result is excess demand for goods and services and pressure on businesses to raise prices in order to increase their profit margins. Possible causes of demand-pull inflation include:

A depreciation of the exchange rate which increases the price of imports and reduces the foreign price of UK exports.  If consumers buy fewer imports, while exports grow, aggregate demand in will rise – and there may be a multiplier effect on the level of demand and output.

Therefore the impact is to make imports less competitive in the UK and to make UK exports more competitive abroad. In principles, this should therefore lead to an increase in the overall value of exports and a fall in the value of imports, leading to an improvement in the current account of the balance of payment. This however is subject to certain conditions holdings.

Firstly, the Marshall-Lerner condition must hold. If the demand for imports (for example) is highly price inelastic, then the UK may end up buying approximately the same number at a higher price. This might mean that the current account balance would actually deteriorate.

The Marshall-Lerner condition generally does hold. In the short run, however, it might not. This is because firms may have pre-existing contracts that they must fulfil, and in any case, it takes people time to adjust to higher prices. As a consequence, it may be that a depreciation of the exchange rate will cause the current account balance to worsen in the short term, while demand is very inelastic, before ultimately improving in the medium term, when the Marshall-Lerner condition holds. This gives the well known j-curves effect, showing what might happen to the current account balance over time.

Secondly, the economy must have spare capacity. The depreciation should lead to an increase in export demand, increasing aggregate demand in the economy generally. If the economy is at sort of supply side constraint (non-accelerating inflation rate of unemployment, full employment), then the increase in aggregate demand will simply cause inflation. This will increase prices in the UK economy, making UK firms uncompetitive again, nullifying the impact of the depreciation. The existence of spare capacity is the primary reason that the depreciation of sterling in 1992 (when the pounds was forced out of the exchange rate mechanism) did not lead to inflationary pressure in the UK.

Thirdly, the economy also needs to avoid the danger of cost push inflation. As the prices of both imported raw materials and imported finished products rise, it is likely that the cost of living is going to increase in the UK. The impact of this is to reduce real wages for UK employees. As a consequence, it is likely that pay demands will increase. If employers in general accommodate these pay claims, and the seek to pass on the increase in costs in the form of higher prices, there is a danger of a wage price spiral, that will push up UK inflation, again eroding the increase in competitiveness brought about by the depreciation in the exchange rate. Therefore, the ultimate effect of depreciation depends on four main variables:

Firstly the size of the initial depreciation

Secondly the general reaction of firms

Thirdly whether or not the Marshall-Lerner conditions holds, and 7fourthly on the current state of the supply side of the economy

The UK has recently faced depreciation of exchange rate which causes by the bank crisis

Higher demand from a fiscal stimulus e.g. via a reduction in direct or indirect taxation or higher government spending. If direct taxes are reduced, consumers will have more disposable income causing demand to rise. Higher government spending and increased government borrowing feeds through directly into 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 causing sharp rise in house price inflation.

Faster economic 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 occurs when firms respond to rising costs, by increasing prices to protect their profit margins. There are many reasons why costs might rise:

Component costs: e.g. an increase in the prices of raw materials and other components used in the production processes of different industries. This might be because of a rise in world commodity prices such as oil, copper and agricultural products used in food processing

Rising labour costs caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low (skilled workers become scarce and this can drive pay levels higher) and also when people expect higher inflation so they bid for higher pay claims in order to protect their real incomes. Expectations of inflation are important in shaping what actually happens to inflation.

Higher indirect taxes imposed by the government – for example a rise in the specific duty on alcohol and cigarettes, an increase in fuel duties or a rise in the standard rate of 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

Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. The fall in SRAS causes a contraction of national output together with a rise in the level of prices.

Inflation also gives central banks room to maneuver, since their primary tool for controlling the money supply and velocity of money is by setting the lowest interest rate in an economy - the discount rate at which banks can borrow from the central bank. Since borrowing at negative interest is generally ineffective, a positive inflation rate gives central bankers "ammunition", as it is sometimes called, to stimulate the economy. As central banks are controlled by governments, there is also often political pressure to increase the money supply to pay government services, this has the added effect of creating inflation and decreasing the net money owed by the government in previously negotiated contractual agreements and in debt.

Monetary and fiscal policy, their nature and relatives importance/ Which government policies are most effective in reducing inflation?

Governments now give a high priority to keeping control of inflation. It has become one of the dominant objectives of macroeconomic policy.

Inflation can be reduced by policies that (i) slow down the growth of aggregate demand or (ii) boost the rate of growth of aggregate supply (AS). The main anti-inflation controls available to a government are:

Fiscal Policy: If the government believes that AD is too high, it may reduce its own spending on public and merit goods or welfare payments. Or it can choose to raise direct taxes, leading to a reduction in disposable income. Normally when the government wants to “tighten fiscal policy” to control inflation, it will seek to cut spending or raise tax revenues so that government borrowing (the budget deficit) is reduced. This helps to take money out of the circular flow of income and spending

Monetary Policy: A tightening of monetary policy involves higher interest rates to reduce consumer and investment spending. Monetary policy is now in the hand of the Bank of England –it decides on interest rates each month.

Supply side economic policies: Supply side policies include those that seek to increase productivity, competition and innovation – all of which can maintain lower prices.

Act (1998) elevates the achievement of price stability ahead of any objective for growth and employment, but also why the Chancellor’s Remit letter gives the MPC a degree of ‘constrained discretion’ in deciding how quickly to correct any deviation from target, so as to avoid creating excessive volatility in output. (Charles Bean, 2011)

Why has inflation remained low in the UK over recent years?

The last twelve years has been a period of very low and stable inflation. No one factor explains this – but among them we can highlight the following:

Low wage inflation from the labour market: Wages have been growing at a fairly modest rate in recent years despite a large fall in unemployment. This has been helped by a fall in expectations of inflation

Low global inflation and deflation in some countries: There has been a clear fall in the average rate of consumer prices inflation among leading economies, and this decline in global inflation has filtered through to the UK. World inflation has stayed low despite the recent increases in the prices of many of the world’s globally traded commodities.

The effectiveness of monetary policy in the UK: The success of the Bank of England through monetary policy in keeping aggregate demand under control through interest rate changes

Increased competition: Many markets have become more contestable in the last decade and this extra competition has placed a discipline on businesses to control their costs, reduce profit margins and seek improvements in efficiency. Many UK businesses face severe pressure from foreign competition as the process of globalisation continues

The strength of the exchange rate: The recent strength of the pound has lowered the cost of imported products and also squeezes demand for UK exporters

Information technology effects: The rapid expansion of information and communication technology has helped to reduce costs and has made prices more transparent for consumers – e-commerce has contributed to falling prices in many markets

In short, low inflation is the result of a combination of demand and supply-side factors.

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