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This essay focuses on Monetary and fiscal policy as one of the essential instruments of microeconomic objectives. It also explains how monetary and fiscal policies are used in the United Kingdom to influence interest rate, money supply and aggregate demand. This aim at providing the full understanding of monetary and fiscal policy in the United Kingdom how interest rate and money supply, government spending and the changes in tax rate affect the UK economic and which policy can be used to stimulate the current recession in the United Kingdom.
Monetary policy can be defined as a means by which a central bank of a country influences their supply of money. It can also be described in terms of interest rate and money supply. The main aim is to influence inflation, growth rate, and aggregate demand.
Monetary policy is an effort to influence macroeconomic objectives during interest rate setting. Monetary policy can be described as a direct instrument mainly because its influence can be felt all over the economy. The United Kingdom practice the Supply side policy monetary policy at present where the government manipulates the rate of interest and this indirectly affects the real variables in the economy
The Bank of England tries to manipulate the entire spending in economy and at the same time controlling inflation just by changing the rate of interest. When interest rate is reduced, it encourages people to borrow than to save which can lead to more spending in the economy. Asset such as property for instance increase in value when they interest rates are reduced which can lead to homeowners spending more, extending mortgages and also consuming more. When there is a cut in the rate of interest, this increase employer spending on feeds through to productivity thereby causing increase in employment. Also when interest rate is increased it has a reverse outcome as people start to save their money than spending them, as a result, reducing the economy total spending.
In the UK the Monetary Policy Committee announced in March 2009 that, in addition to setting Bank Rate at 0.5%, in order to meet inflation target money will be injected straight into the economy. The monetary policy tool moved towards the provision of the quantity of money rather than its price which is also known as the bank rate. But the purpose of the policy remains unchanged which is, to meet the inflation target at 2% on the CPI measure of consumer prices. Influencing the quantity of money directly is effectively a different way of reaching the same conclusion.
Important decrease in Bank Rate have provided a huge motivation to the economy but as Bank Rate become closer to zero, additional decrease are likely to be less successful in relation to the influence on inflation, market interest rates, and aggregate demand . And interest rate is likely to be less than zero. The Monetary Policy Committee as a result needs to provide additional incentive to support demand in the vast economy. Inflation will drop below its target if spending on goods and services appears really short.
The MPC boosts the supply of money by buying assets like Government and corporate bonds, this is a policy often known as ‘Quantitative Easing’. This is where the bank of England pumps additional money directly instead of reducing Bank Rate to increase the amount of money in the economy. This does not involve printing more banknotes. Instead the Bank pays for these assets by creating money through electronic means and crediting the accounts of the companies it bought the assets from. This extra money supports more spending in the economy to bring future inflation back to the target.
The main influence of prices comes through the exchange rate. An increase in interest rate in relation to those in other countries is likely to result in increase in the amount of fund flowing in the United Kingdom, as higher pounds sterling interest rates attract investors. This will result in exchange rate against other countries being valued. In theory, both potential about future interest rates and any unforeseen changes will influence the exchanges rate. Therefore, if investors expect increase in interest rate, they are likely to increase the amount they invest in currency before interest rates actually arise. That is, the relationship between the rate of interest and exchange rate is not that simple.
Other things being equal, an increase in the value of pounds will reduce the price and this is because many imported goods are included in the CPI, this will affect inflation directly. In addition, an increase in pound is likely to decrease the demand abroad for UK goods and services. Any fall in export demand will, in turn, reduce output, as will any shift of domestic spending to imported goods. A decrease in interest rate is likely to the opposite effect.
In the United Kingdom the supply of money of money is controlled in order to stimulate the economy. The interest rate would increase or decrease aggregate demand mainly by increasing the supply of money. Money supply can be controlled using different measure. Using open market operations the government could issue debt to the non-financial sector and increase the money supply and buy back debt when it wanted to decrease it. Besides, the supply of money could be controlled by using monetary base control. The Bank of England can influence the activity of the commercial banks indirectly by using reserve assets and this can therefore influence aggregate demand. The UK government has used inflation targeting to keep both inflationary expectations visible but to also achieve its vital goal of price stability. There are many problems associated with monetary policy. Monetarists believe that inflation is always and everywhere a monetary experience and that the changes in money supply or interest rate will significantly have an impact on aggregate demand.
Keynesians argue that this not the case as they only influence aggregate demand only to some extent. These conflicting viewpoints make it difficult for policy makers to review the impact of monetary policy. In addition, with a wide range of contradictory measures of inflation such as the RPI, and others, the actual illustration of inflation in the economy is almost impossible to measure. The bank of England has solved this by using the RPIX measure. Monetary policy is not impulsive; changes in the rate of interest don’t affect the UK economy until about 2 years later. Uncertainty makes the MPC decisions very questionable. With a globalised economy where many economies such as the UK are open supply side and demand side changes monetary policy needs adjust. The frequency of meetings and changes in personal every sixth months give the MPC the flexibility that is associated with this. The lack of data is the last limitation to monetary policy. There are many measures but also measures are revised and change quarterly highlighting how difficult it is too assess the keep prices stable.
Fiscal policy is the means by which government adjust its levels of spending in the order to scrutinize and influence a nation’s supply. It is also means Government spending policies that influence microeconomics conditions. It is a situation where the government changes the tax level and government spending to influence the level of aggregate demand. The aim of fiscal policy is to reduce inflation, motivate the economic growth and to stabilize this growth. If monetary policy is described as a direct tool then fiscal policy is a the exact instrument that can target particular sectors of the economy and population in order the desires changes in the economy.
Keynes also believes a government should use fiscal policy to stimulate an economy slowed by a recession by running a deficit, that is, by spending more than it takes from the economy in taxes. Fiscal policy can be influenced through manipulation of government expenditure and tax system.
During Gordon Brown’s period as Chancellor, the Labour Party formally adopted the ‘Golden Rule’ of fiscal policy. The Golden Rule states that over the full economic cycle, the government should only borrow to invest for future needs. Current needs should be met by tax revenues. This should allow for stable finances as defined by the ratios of public sector net worth, debt and current expenditure to national income.
In conjunction with the Golden Rule, the UK government also seeks to follow the Sustainable Investment Rule, which should keep national debt at a sensible level currently set at 40% of GDP. By the end of 2008 estimated public debt had already risen to 42 per cent, and could rise to 70 per cent of GDP by 2010, meaning that the Sustainable Investment Rule has been broken. The explanation is that a severe needs Keynesian motivation to revive it, and that balancing the books should only be sought once the economic recovery begins.
Fiscal policy is the most successful in achieving microeconomic objectives through taxation and borrowing. For instance, when the starting rate was of income tax was recently cut by the government. This encourages low income earners to work more hours as this enable them to keep more of what they earn. Depending on the level of inflation that is determined by monetary policy, they can either save or spend their income.
The government also introduced a 2.5% reduction of the rate of value added tax last year. This government introduced this by the year as a way of improving spending, especially in the run up to the rush of Christmas period. Nevertheless, this has not had the desired effect on household spending which is at its lowest level since 1991 (ONS, 2009).
All of which would through fiscal policy increase the size of the UK government’s budget surplus, through an increase aggregate supply. Although the fall in taxes, causes increased disposable income for consumers, and higher after-tax profits for businesses; both of which usually lead to a higher level of aggregate demand for goods and services. However the danger of reducing the overall burden of taxation too much is that it might lead to excess demand and therefore lead to a build up of inflationary pressure. Such as under Thatcher’s Conservative leadership, whereby after 1987, when she lowered the tax burden, excess demand was seen, which led to the high inflation in the turn of the decade.
The government stimulates the spending in the economy by trying to borrow more money in order to fund tax cuts and increased spending in social programs. though, the effect of this may be that people are realizing that they may face a higher tax burden in the future because of this increased spending and so are saving more in anticipation of this.
Another factor that may affect the size of the UK government’s budget is the equilibrium between government spending and tax revenue on the annual budget balance can be affected hugely by small percentage changes. Such as when the economy is strong, the budget position can improve very quickly. Equally, if there is an economic slowdown, there can be a rapid deterioration in the government’s financial position.
Both monetary and physical policy should work hand in hand in other to work in other to achieve microeconomic objectives in any developing and sustainable economy. In a retreating economy being currently witnessed in the United Kingdom, there need to be a balanced between the two policies.
Even though monetary and fiscal policies work together the most effective way in boosting aggregate demand in the current economic situation in the UK is fiscal policy.
Fiscal policy is employed by the government in other to meet the microeconomic objectives, purposely by adjusting the levels and allocations of taxes and government expenditures. In a situation when economic is slow the government may cut taxes, leaving extra bit of cash for the taxpayer to spend and in a way the level of consumption increases. An increase in public spending may equally pump cash into the economy, having an expansionary effect. Fiscal policy is more effective at boosting a deteriorating economy such as the one currently in UK than at cooling an inflationary one.
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