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Government policy proposals using the National Income diagram

        Sustained growth in economic prosperity is a key desire for all economies of the world, in which to heighten levels of the world's living standards. Government policies aim to pursue such objectives, via analysis through the National Income diagram of the implications of each policy. The National Income diagram was first proposed during the 1930s by John Maynard Keynes based on the theory from the Circular Flow of Income model. Changes in the level of national income imply changes in the level of GDP, and so is a useful tool to estimate changes in economic growth. Full employment of economic resources is a virtue Government's pursue; however, levels of national income are always underestimated due to issues arising from the non-monetised economy, black economies and externalities etc. A rise in GDP may not always give rise to levels of living standards. The effect of discretionary policy changes are analysed with effect upon changes in the levels of withdrawals and injections, the latter being the adjustment of aggregate demand (aggregate expenditure).

        2008 witnessed the emergence of the financial crisis, which streamed through open economies of the world, primarily caused by the mishap of the US sub-prime mortgage industry. Inevitably this caused a fall in national income, which lead growth in GDP in negative territory. The resulting issue is shown below on the National Income and AD/AS diagram.

As illustrated from Figure 2, current levels of national income (Ye) is far below the full employment level (Yfe); the level the economy should be if it were growing in line with the long-term trend rate of growth. This is shown via the deflationary gap that emerges as a result from the recession; also indicating that spare capacity is being underutilized. This is further elaborated through the AD/AS diagram, illustrating that in times of a recession, consumer spending falls, in essence leading to a leftward shift in the AD curve (Figure 1). Figure 1 portrays a negative output gap, illustrating the cause of demand deficient unemployment.

An efficient way to counteract the effects of the 'credit crunch' is by the use of demand management policies; which incorporates Fiscal policy (using fiscal instruments such as changes in Government spending and taxation) and Monetary policy (using monetary instruments such as the control of the money supply and changes in interest rates), in order to influence the level of aggregate demand. Such a policy is a crucial aspect of Government policy, but both expansionary fiscal and monetary policy need to be implemented with the intention of them both being interdependent. Proposed policies would need to successfully shift the injections line (J1) upwards to J2. Injections, being an exogenous variable will only effect national income if there is a likewise shift in aggregate expenditure (E).

A primary fiscal stance would be to inject funds into the economy via fiscal stimulus packages, coupled with a reduction in the rate of interest set by the Bank of England. Yes the Government would be running a budget deficit, however low interest rates would minimise the effects of fiscal crowding out. This ensures that an expansionary fiscal and monetary policy will help initiate the multiplier and the accelerator process. Government investment in increasing the stock of national assets (shifts the injections curve upwards from J1 to J2 in Figure 3), ensures an improvement in public sector employment, in turn leading to an increase in nominal wages, the latter being an increase in national income. This provides an improvement in the supply-side capacity of the economy in the long-term. One of the major controversies currently posed between the pre-election Government candidates (Labour Vs Conservatives), is whether to continue fiscal injections into the economy, or to start reducing the national debt; (which currently stands at £848.5 billion), King, I. (2010). 'Worried about national debt? Things are worse for Mr and Mrs Average', Times Online, 19 February.

Economic growth from the fourth quarter of 2009 was recently revised upwards to 0.3% from 0.1%. This does show that the UK economy is experiencing growth; however there is still a debate whether the recovery will be short-lived and the UK witnessing a 'double-dip', if resistive factors such as increases in taxes or cuts in Government spending are implement prematurely.

Analysis via the ISLM (Interest/savings - liquidity money) curve shows equilibrium in the goods and the money market. An initial increase in Government expenditure or investment will cause the injections curve to shift upwards (as shown in Figure 3), this consequently will lead to a proportionate shift in the IS curve rightwards, thereby increasing the level of national income. However such a stance (according to Figure 4) will cause an increase in interest rates which will crowd out private sector investment. After the injection of fiscal stimulus packages, to counteract higher interest rates, the Bank of England has devotedly indulged upon quantitative easing. This in effect increases the supply of money and hence causes a rightward shift in the LM curve. This move ensures that both the money and the goods market clear at a higher level of national income, yet having no upward pressure on interest rates; as shown in Figure 4. The effectiveness of fiscal policy would be determined by the elasticity of the LM curve. The more elastic the curve is the more effective fiscal policy is. The current problem facing the Monetary Policy Committee is that interest rates can no longer go down. As a result an increase in the money supply, via the Bank's quantitative easing programme will have no effect on the economy. In such a climate, firms and individuals prefer to increase the liquidity of their asset holdings; therefore the additional money injected into the economy will be left as idle balances. This is what Keynes referred as the liquidity trap.

One of the Government's aims during times of a recession is to minimise the growth in withdrawals and to encourage consumption, as to increase injections into the economy. Even though interest rates are at their lowest, current statistics shows that the current household savings ratio is at its highest, inflating the amount of withdrawals. The first quarter of 2008 showed a savings ratio -0.7%, whereas the third quarter of 2009 showed a savings ratio of 8.6%, Office for National Statistics. (2010). Household sector: Use of Disposable Income Account. Such results may have damaged the credibility of monetary policy, as a result of the lack of confidence among consumers. One way of retaining such credibility, as proposed by Olivier Blanchard, the IMF's chief economist is through bold innovations, "the most radical of these is that central banks should raise their inflation targets - perhaps to 4% from the standard 2% or so". The ideology behind this statement is that primarily before the 'credit crunch' interest rates and inflation were both low, as a result there was little room to cut rates. What concerns economists is that whether such a policy would convince investors that monetary policy would be more flexible in responding to economic shocks, or whether it is just intended to "inflate away state debts". The Government may pursue such objectives in order to salvage the AAA credit rating of the UK, however having pledged to keep inflation close to 2% would destroy consumer & investor confidence upon monetary policy. However prior to implementing such a radical policy, there's a need to undertake cost-benefit analysis, Blanchard, O. Et al. (2010), IMF.

        The sterling exchange rate is also having a big influence on the UK economy. "On March 1st it lurched down against the dollar by 2% ..., this latest plunge makes sterling the weakest of the main currencies this year", The Economist. (2010). Sterling throws a wobbly. The Economist. 394 (8672). P31. The weak pound enables export industries in the UK to facilitate orders, whereby improving the UK's international competitiveness, thus allowing the UK to get a grip on its competitive advantage. The significance of the weak pound ensures a boost in injections and curbs down withdrawals, in essence increasing aggregate demand. Analysis via text-book theory suggests the UK is in an advantageous position. However for exports to push forward there must predominantly be a parallel adjustment in imports from other economies. The effect of the current global financial crisis has eroded away demand for the UK's exports, slowing down growth in exports. However, the weak pound does come at a higher price. The UK being a major importer of raw materials to fuel various industries, coupled with a rise in petrol prices, has caused a surge in import prices; thus leading to cost-push inflation. As a result the current inflation rate stands at 3.5% CPI, significantly higher than the Bank of England's 2% target, National Statistics Online: Inflation Report. The Government usually appreciates a strong exchange rate; therefore it is quite possible for the MPC to raise interest rates to stop the exchange rate depreciating further. A higher exchange rate helps to increase demand for the pound, as it is more attractive for foreign investors to deposit money into British banks.

If demand management fails, there's always plan B; in the form of supply-side policies. Supply-side policies can affect aggregate demand, indirectly. The Flexible New Deal programme implemented in October 2009, a reincarnation of the one implemented by the Labour Government in 1998, focuses on aspects to improve the workings of the labour market. The programme emphasises the importance of reducing unemployment, hence providing education and re-training facilities for those who were structurally unemployed.

The structurally unemployed who are indebted with the lack of transferable skills, helps them into industries with growth potential, such as in IT. Flexibility of the labour market is also an important aim, enabling the labour market to adapt efficiently with fluctuations in economic activity, hence providing the unemployed with more flexible time shifts, or temporary employment. Also, reducing the rigidity of the labour market through trade union reforms ensures the side effects of strike action are restricted. Successful implementation of supply-side policy ensures a higher level of national income through greater levels of injections into the economy via increases in spending. A fall in unemployment benefits provides greater use of public funds on more productive uses, the latter being a successful increase in aggregate demand.

        In essence demand management and supply-side policies are effective in their own right, however measuring the effectiveness of each policy proposal is crucial. The time-lag associated with each policy must be dealt with accordingly to minimise that changes in the economy do not deviate away from the business cycle. The multiplier, in theory is an efficient process whereby to accelerate the growth potential of the economy. However, as mentioned that the marginal propensity to save is increasing, this indicates that the marginal propensity to consume thus falls. As a consequence the value of the multiplier becomes less significant, as individuals hold money with a precautionary motive. Individuals therefore have become less sensitive to policy changes, hence the prolonged recovery and a high probability of a 'double-dip recession'. This is further elaborated via the assumptions of rational expectations. During the current climate, a rational individual expects that future levels of taxes will rise in order to diminish the Government's budget deficit. As a result the individual will bring forth savings in exchange for consumption, given the assumption that their future income is unlikely to increase. Therefore, an increase in Government spending will have no significant effect on aggregate demand, given that the extra funds would be saved, overall increasing withdrawals. Supply-side policies is a must, ensuring that the long-run aggregate supply curve (as shown in Figure 1) shifts to the right, showing an improvement in the supply-side capacity of the economy. In the long-term this ensures that unemployment is minimised, and that there is no upward pressure on inflation via demand-pull inflation when periodically demand exceeds capacity. Overall national income will inevitably increase, but when and by how much is a debatable argument. With the up-coming general election and a probability of a hung parliament, it is quite difficult to judge which specific policies will be implemented.

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