Macroeconomic policies

Government macroeconomic policies In order to achieve its objectives, the government uses 2 main types of policies: Demand-side policies –Policies to influence aggregate demand in order to achieve objectives Monetary policy Fiscal policy Supply-side policies –Policies to influence long run aggregate supply (to increase it)

Monetary policy In general, monetary policy is the manipulation by a government of monetary variables such as interest rates and the money supply to achieve its objectives (In the UK) monetary policy is the manipulation of interest rates, and the use of quantitative easing, to influence aggregate demand in order to achieve price stability. Subject to this, monetary policy supports the Government’s other economic objectives –Price stability is defined by the Government’s inflation target of 2% measured using CPI –As we have just looked at, price stability is important in providing the right conditions for sustainable growth in output and employment In the UK, monetary policy is conducted by the Bank of England, which is independent

How monetary policy operates in the UK The principal way monetary policy works is through changing interest rates in order to influence aggregate demand –When demand exceeds supply, inflation tends to rise above the 2% target, and so the Bank raises interest rates to reduce AD. –The interest it changes is called the base rate, which is a short term interest rate. As a result, commercial banks (HSBC, NatWest etc) raise their interest rates –On the other hand, when supply exceeds demand, inflation tends to fall below the Bank’s 2% target, and so the Bank reduces interest rates to stimulate AD SRAS Price Level AD YfYf P 0 LRAS

Economic Effects of Interest Rate Changes Interest Rate Changes Will Impact: Housing MarketCredit Demand InvestmentSaving Exchange Rate Higher interest rates makes it more attractive to save money in UK bank accounts, which means higher demand for £, so £ rises, so X↓ and M↑ which means AD falls. These money flows are called hot money Higher interest rates means demand for loans falls as households will borrow less to buy consumer durables like cars, so C↓ and AD ↓ Higher interest rates means savings are more worthwhile, so households save more which means so C↓ and AD ↓ Higher interest rates increases the cost of borrowing for firms in order to buy capital equipment, which means investing in capital stock is less worthwhile, so I↓ and AD ↓ Examiner favourite when interest rates are falling if interest rates are cut, many homeowners may increase the mortgage (loan) on their house, and spend this. So leading to C↑ and thus AD↑ A less certain effect. Higher interest rates increases the cost of mortgages, which reduces the demand for houses. House prices might fall so wealth effect so C↓ and AD↓. Fewer people moving house means lower demand for house-related products (no replacement kitchens, redecoration etc), so C↓ and AD↓

How quickly does monetary policy work If AD is too strong (AD 2 ), which means inflation will be rising, the Bank of England will raise interest rates in order to reduce aggregate demand How quickly will AD fall? There are time lags. Whilst the impact will start quickly, it takes up to two years for effects to be fully realised in the economy, so the Bank of England has to estimate what inflation will be in 1-2 years time. The time lags to consider: –How long after Bank of England changes rates before market interest rates change eg mortgage rates? –How long before consumers save more, spend less? –How long before this means firms reduce output and make staff redundant? SRAS Price Level YfYf 0 LRAS AD 2

Quantitative Easing (QE) After the financial crisis of 2008, central banks cut interest rates to virtually 0 (0.5% in the UK), yet aggregate demand did not recover sufficiently Conventional monetary policy was therefore ineffective –Interest rates could not easily be cut further –Lower interest rates were not stimulating extra demand - perhaps consumers and firms were not confident, and therefore did not spend more as interest rates were cut As a result, central banks, including in the US and UK introduced an unconventional form of monetary policy called quantitative easing (QE) Quantitative easing is where a central bank creates new money electronically to buy financial assets, like government bonds. This process aims to directly increase private sector spending in the economy and return inflation to target

How QE works – bond primer Bonds are issued by firms or the government in order to borrow money. These bonds are bought by investors, eg pension funds (investors in this case means investing money not buying machinery). The government issues bonds to finance the budget deficit When the government issues a bond, it promise to pay a certain fixed cash amount each year to the ‘investor’ who buys the bond, and then to repay the original amount borrowed sometime in the future For example, the government may issue £100m bonds to investors (so borrowing £100m). For each £100 held, the government may pay eg £4 income In this case, the rate of interest, or yield, the investor receives is 4% (£4 each year for an investment of £100) Government bonds can be bought or sold on bond markets, and so prices can go up or down. If demand for bonds rises, then the price of a bond rises, which means the interest rate, or yield, falls: –For example, if the price of this bond rises to £120, an investor buying this bond in the market will receive £4 a year. This is a yield of 3.33% (£4 each year for an investment of £120)

How QE works – the works! The Bank of England buys bonds from private sector financial firms, such as pension funds, using money it has created electronically (it credits the seller’s account). Creating money increases the money supply. QE has 3 main effects: –The price of these bonds increases. This means yields fall which means interest rates fall, which can stimulate both investment and consumption (Advanced: this affects longer term interest rates which conventional policy of changing the base rate does not) –Investors have received money from the Bank of England, and will then buy other financial instruments such as shares. This means asset prices in general increase, which means an increase in wealth. The increase in wealth will encourage consumers to spend more –There will be an increase in the money supply. This is because there will be an increase in deposits at banks, which means banks will be able to lend more money to firms and households, so investment and consumption may increase. Evaluation: does not mean they will lend more To date QE has totalled £375bn, £325bn of which has been government bonds. Has QE worked? –Since the financial crisis, banks have not been very willing to lend, and so this part was not effective. Overall though, QE has probably meant GDP was higher than without QE so yes it has worked

Monetary Policy Committee In the UK, monetary policy is decided by the Bank of England’s Monetary Policy Committee (MPC), which is independent from Government. David Cameron and George Osborne cannot tell the Bank of England to change interest rates The MPC has 9 members –Governor Mark Carney plus 4 from the Bank of England (including 2 Deputy Governors) –4 external members appointed by the Chancellor The MPC votes each month on whether to change interest rates or QE in order to meet the mandate from the Chancellor of the Exchequer, which is inflation of 2% Economic data is considered to assess the potential of each indicator to impact inflation The MPC has to consider this data, and make a judgement about what inflation is likely to be in 1-2 years time if they do not change policy –If they think it will be above 2% and rising, then they will tighten policy – raise interest rates –It they think it will be below 2% and falling, they will loosen policy – lower interest rates or increase QE The Governor writes a letter to the Chancellor if inflation is 1% below, or 1% above target (below 1%, above 3%)

MPC setting the interest rate… Economic Data for Consideration Housing MarketCredit Demand InvestmentRetail Sales Exchange Rate Rate of GDP Growth Wage Inflation Manufacturing Output Unemployment MPC must consider all these things in the economy to assess the inflationary pressure that is likely – decide whether they need to change interest rates to achieve 2% inflation target.

Economic indicator How it will affect inflationary expectations… Investment If it is rising, then this will increase AD in the short run, causing Demand-Pull inflation. (In the longer term, it might lower production costs through greater efficiency reducing inflation again if AS shifts out) If it is falling then… Unemployment If it is rising, then… If it is falling then… Housing Market If it is rising, then… If it is falling then… Rate of GDP Growth If it is high, then… If it is low then… Exchange Rate If it is rising, then… If it is falling then… Wage Inflation If it is high, then… If it is low then… Credit Demand If it is rising, then… If it is falling then… Manufacturing Output If it is rising, then… If it is falling then… Retail Sales If it is rising, then… If it is falling then…

Criticisms of Monetary Policy Difficult to assess state of the economy based on monthly data, so the wrong decision might be taken Time lags – takes up to two years for effects to be fully realised in the economy, so the Bank of England has to estimate what inflation will be in 1-2 years time. They might get this wrong Related to time lags, global economic conditions may change rapidly and unexpectedly. For example, a collapse or surge in oil prices, or a collapse in the Chinese economy Low interest rates may not be effective in stimulating demand when firms and consumers are not confident about the future Quantitative easing is not proven. Some economists think it has worked (including those from the Bank of England), some think not