Copyright 2007 – Biz/ed Monetary Policy Attempts to influence the level of economic activity (the amount of buying and selling in the economy) through changes to the amount of money in circulation and the price of money – short-term interest rates. Interest rates the key area of Monetary Policy
Copyright 2007 – Biz/ed Monetary Policy Short-term interest rates set by the Monetary Policy Committee (MPC) of the Bank of England Meets for 2 days each month to decide on rates The ‘official rate’ is the rate at which the Bank of England will lend to the financial system and influences the structure of all other interest rates
Copyright 2007 – Biz/ed Monetary Policy
Copyright 2007 – Biz/ed Monetary Policy Basis of Monetary Policy is that there is a long run relationship between the amount of money and inflation Demand for Money – the amount people wish to hold as cash as opposed to other assets The Supply of Money – the amount of money in circulation in the economy
Copyright 2007 – Biz/ed The Classical Quantity Theory of Money: MV = PY –(where M = the money stock, V = velocity of circulation, P = price level and Y = level of national income More formally: Monetary Policy
Copyright 2007 – Biz/ed Monetary Policy M d = k PY where: –P is the price level –Y is the level of real national income –M d is demand for money for transactions purposes –K = proportion of national income held as transactions balances In equilibrium M d = M s –So: P = 1/kY x M –A rise in Ms will lead to a proportional rise in P
Copyright 2007 – Biz/ed Monetary Policy Supply of Money: –Narrow Money – notes and coins in circulation (M0) –Broad Money – Notes and coins plus money held in bank and building society accounts (M4) A rise in either (ceteris paribus) might signal a rise in aggregate demand (AD)
Copyright 2007 – Biz/ed Monetary Policy The Interest Rate Transmission Mechanism –The process by which a change in interest rates feeds through to AD
Copyright 2007 – Biz/ed The Interest Rate Transmission Mechanism 2 Interest Rates Mortgages Existing New Consumption Investment Disposable Income Property Equity Demand for New Housing SavingsConsumption
Copyright 2007 – Biz/ed The Interest Rate Transmission Mechanism 3 Interest Rates Exchange Rates Appreciation Mp Xp Dm Dx Depreciation Mp Xp Dm Dx Balance of Payments
Copyright 2007 – Biz/ed Supply Side Policy
Copyright 2007 – Biz/ed Supply Side Policy Intention is to shift the aggregate supply curve to the right, increasing the long term productive capacity of the economy Tend to be long-term policies Arguments about how effective they are – e.g. lowering taxes increases incentives, reducing welfare dependency increases the urge to find work
Copyright 2007 – Biz/ed Supply Side Policy Inflation Real National Income AS Yf AS1 Yf2 AD 2.3% 2.0% Supply side policies can help to push the AS curve to the right increasing the capacity of the economy from Yf to Yf2 Increases in long-term capacity can help the economy to grow without undue pressure on inflation.
Copyright 2007 – Biz/ed Supply Side Policies Policies aim to influence productivity and efficiency of the economy Key feature – open up markets and de-regulate to improve efficiency in the working of markets and the allocation of resources
Copyright 2007 – Biz/ed Supply Side Policy Main areas of policy: –Labour Market – reduce impediments to free market, reduce bureaucracy and ‘red tape’ – flexible labour markets –Reduce power of trade unions – legislation of the eighties still has an impact in this respect –Short term contracts –Flexible working arrangements –Hiring and firing –Contracts, terms and conditions, pay –Criticism of such policies is that they put the needs of employers above those of workers which can lead to exploitation
Copyright 2007 – Biz/ed Supply Side Policy Tax and Welfare Reform: –More stringent benefit regime –Tax reform to encourage people to work –Improving access to training and education –‘New Deal’ scheme
Copyright 2007 – Biz/ed Supply Side Policy Education and Training: –Reform of 14 – 19 education –Modern Apprenticeships –National Qualifications framework – coherent set of qualifications –Expansion of vocational qualifications –Expansion of university access
Copyright 2007 – Biz/ed Supply Side Policy Incentives and technology: –Tax reform to encourage incentives and entrepreneurial spirit –Incentives to develop new technology – investment –Drive to embracing ‘knowledge driven economy’ –Regional policies to encourage enterprise, investment, location, expansion
Copyright 2007 – Biz/ed Fiscal Policy
Copyright 2007 – Biz/ed Fiscal Policy Influencing the level of economic activity though manipulation of government income and expenditure Associated with Keynesian Demand Management Policies Now seen in wider terms:
Copyright 2007 – Biz/ed Fiscal Policy Also used to influence non- economic objectives and provide framework for supply side policy e.g. education and health, poverty reduction, welfare reform, investment, regional policies, promotion of enterprise, etc.
Copyright 2007 – Biz/ed Government Income Tax Revenue Sale of Government Services – e.g. prescriptions, passports, etc. Borrowing (PSNCR)
Copyright 2007 – Biz/ed Public Sector Income Source:
Copyright 2007 – Biz/ed Government Income (£ billion) Source: Inland Revenue Income Tax (gross of tax credits) Income Tax Credits Corporation Tax Windfall Tax Petroleum Revenue Tax Capital Gains Tax Inheritance Tax Stamp Duties NICs Total Inland Revenue
Copyright 2007 – Biz/ed Government Income (£ billion) Source: Customs and Excise VAT Fuel Duties Tobacco Duty Spirits Duties Wine Duties Beer and Cider Duties Betting and Gaming Duties Air Passenger Duty Insurance Premium Tax Land Fill Tax Climate Change Levy Aggregates Levy Customs Duties and Levies Total Customs and Excise
Copyright 2007 – Biz/ed Government Income (£ billion) Source: VED Oil Royalties Business Rates Council Tax Other Taxes and Royalties Net Taxes and NICs conts Interest and Dividends Gross Operating Surplus and Rent Other Receipts and Accounting Adjustments Current Receipts
Copyright 2007 – Biz/ed Government Income – Inland Revenue Source:
Copyright 2007 – Biz/ed Government Income – Customs and Excise Source:
Copyright 2007 – Biz/ed Other Government Income Source:
Copyright 2007 – Biz/ed Fiscal Policy Need to remember subtleties in use of fiscal policy –Adjustment of income tax allowances rather than rates of income tax –Extending or amending range of goods covered by VAT –Changing the rules under which tax has to be paid – married persons allowances, inheritance taxes, stamp duties, etc. –Abolishment of certain tax allowances – MIRAS (Mortgage Income Relief At Source) –Accusations of ‘stealth taxes’ – much of it is a ‘tinkering’ with the tax system to achieve certain aims – mostly non- economic (governments these days, for example, rarely ‘increase taxes’ to dampen down the economy) Be aware of these subtleties when you are writing!
Copyright 2007 – Biz/ed Government Expenditure Social Security Law and Order Emergency Services Health Education Defence Foreign Aid Environment Agriculture Industry Transport Regions Culture, Media and Sport
Copyright 2007 – Biz/ed Public Spending Source:
Copyright 2007 – Biz/ed Public Sector Net Cash Requirement (PSNCR) Source:http://www.hm-treasury.gov.uk/media//E3CCB/PublicFinancesDatabank XLS
Copyright 2007 – Biz/ed The Golden Rule! Fiscal policy framework The Government's fiscal policy framework is based on the five key principles set out in the Code for fiscal stability - transparency, stability, responsibility, fairness and efficiency. The Code requires the Government to state both its objectives and the rules through which fiscal policy will be operated. The Government's fiscal policy objectives are:
Copyright 2007 – Biz/ed The Golden Rule! over the medium term, to ensure sound public finances and that spending and taxation impact fairly within and between generations; and over the short term, to support monetary policy and, in particular, to allow the automatic stabilisers to help smooth the path of the economy.
Copyright 2007 – Biz/ed The Golden Rule! These objectives are implemented through two fiscal rules, against which the performance of fiscal policy can be judged. The fiscal rules are: the golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending; and the sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level. Other things being equal, net debt will be maintained below 40 per cent of GDP over the economic cycle.
Copyright 2007 – Biz/ed The Golden Rule! The fiscal rules ensure sound public finances in the medium term while allowing flexibility in two key respects: –the rules are set over the economic cycle. This allows the fiscal balances to vary between years in line with the cyclical position of the economy, permitting the automatic stabilisers to operate freely to help smooth the path of the economy in the face of variations in demand; and –the rules work together to promote capital investment while ensuring sustainable public finances in the long term. The golden rule requires the current budget to be in balance or surplus over the cycle, allowing the Government to borrow only to fund capital spending. The sustainable investment rule ensures that borrowing is maintained at a prudent level. To meet the sustainable investment rule with confidence, net debt will be maintained below 40 per cent of GDP in each and every year of the current economic cycle. Source of information about the Golden Rule: Crown Copyright, reproduced under licence
Copyright 2007 – Biz/ed Fiscal Policy In Action Inflation Real National Income AS AD 2.0% U=5% Assume an initial equilibrium position with a level of National Income giving an unemployment rate of 5% (U = 5%) If government ‘reduces taxes’ (remember the subtleties) and or increases spending, it will have various effects: AD=C+I+G+(X-M) Apart from G, C and I are also likely to be affected directly or indirectly by the policy change. AD 1 AD therefore shifts to the right to AD1 2.5% U=3% The rise in AD leads to an increase in real national income, ceteris paribus, unemployment would fall to 3% but at a cost of higher inflation
Copyright 2007 – Biz/ed Fiscal Policy In Action Fiscal Policy influences AD in the short term but can be used to affect AS in the long run – depending on the nature of the policy. Try your hand at Fiscal Policy by going to the Virtual Economy (http://www.bized.ac.uk/virtual/econo my/policy/advisors/fiscal.htm)