Theme 2 The UK Economy: Performance and Policies

Essay 5: Brandon Bland

Evaluate the view that higher inflation in a developing economy might be advantageous.

Inflation exists when there is a general increase in price levels and a fall in purchasing value of money. A developing country is a with low average income that is seeking to become more advanced economically and socially. An example of a county like this is Tanzania. Inflation can be advantageous if caused by increases in AD which is caused by a growth in exports. Some of Tanzania's exports include gold, coconuts, and brazil nuts. Tanzania's exports outweigh their imports giving them a positive balance of trade. This sort of inflation can be advantageous, as it is caused by economic growth. The knock-on effects of economic growth are that in the short term there may be high inflation, but in the long term it will lead to there being much more money in the circular flow meaning the economy will be stronger, creating new jobs for people, which reduces unemployment. This will also increase standards of living and potentially allows for development in areas such as education, health, and infrastructure. The diagram below shows how an improvement in net imports increases inflation. Because of an initial injection from export earnings, AD shifts outwards (Y1 moves to YP) and causes inflation (PL1 moves to PL2). After the multiplier effect it increases inflation even further (PL2 moves to P3). A multiplier is when an injection in the circular flow of income passes through an economy and leads to further economic growth. This is a favourable situation for a country like Tanzania as long term economic growth is essential for economic development of the country and therefore we see that higher inflation might be advantageous.

However, if inflation is higher than wages then living standards will decrease because everything will be more expensive for people to buy in real terms. For example, farmers will need to spend more money on producing the goods that they sell, so they will have to increase the prices of what they are selling so that they are still making enough of a profit. This means that people will be paying more for the same product that they used to pay for. For the wages to increase it will depend on the bargaining power of the workers, and possibly whether they are in a union, because if they are in a union, they will be able to strike against wages not increasing. And if the workers do this it will encourage their employers to increase their workers' wages rather than finding new workers. This in turn can fuel further inflation as firms pass on their increased wage costs onto consumers in the form of higher prices. In this situation there is the risk of a wage-inflation spiral, which if not stopped could lead to very high rates of inflation, even hyperinflation, which is extremely damaging as the value of money can become virtually useless.

Inflation can be advantageous if caused by increases in AD which are caused by investment. Investment is spending on capital goods. An example of this is the Tanzanian government using their funds for capital. This can include building new train lines, or funding the construction of hospitals, etc. In the short run investment will lead to an outward shift in AD which will cause inflation to increase. This will then cause the cost of living to increase, which leads to a decrease in standards of living. But in the long run investment can also lead to an outward shift in AS, this means that there will be long-run economic growth and living standards will rise. Furthermore, this means inflation will go back down as demonstrated in the diagram below. The starting point is (Y1, PL1). After investment the AD curve shifts outwards, and so does the AS curve. This creates a new long-run equilibrium at (Y2, PL2).

However, if inflation is too high, then this will discourage investment. Firstly, if the market is too volatile it is too risky to investors who are likely to wait for stability, causing an inward shift of AD. Secondly, if inflation is too high then the central bank will likely increase interest rates, meaning it costs more to borrow money, and this means investors will be less willing and able to invest causing a further inward shift of AD. For example, a Tanzanian coconut firm will not look to expand when inflation and interest rates are high as the cost of borrowing is too much.

In a developing country inflation is expected with economic growth. This is acceptable as long as the inflation is controlled. But if inflation is too high then this will be a disadvantage to the economy because it will prevent any further economic growth. Central banks set targets for inflation in order to avoid deflation and keep inflation within controllable levels. If done successfully then countries like Tanzania can expect inflation to occur as they grow and overall this would be advantageous.

Essay 6: Anzie Baiden

In an economy with weak growth, evaluate the likely impacts of a government attempting to reduce a significant budget deficit.

A budget deficit occurs when government spending is greater than tax revenues. Attempting to reduce a significant budget deficit can lead to a slower rate of economic growth meaning that living standards will increase at a slower rate too. Economic growth can be defined as the rate of change of output within an economy.

Firstly, weak economic growth and unemployment can be caused by a decrease in government spending. Fiscal austerity can be achieved by a reduction in government spending or future spending commitments. Largely, austerity policies, which reduce government spending, lead to increased unemployment in the short term.

The diagram begins with national equilibrium at Y1 and P1. The AD curve then shifts inwards to show the effects of when government spending is cut. For example, between 2010-2013 the government reduced public spending by £14.3 billion to reduce the budget deficit. Unemployment increases due to the government spending less income in different sectors therefore, employees will be made redundant due to less derived demand for labour. For example, during the austerity years (2012-2019) the UK government cut spending on government services such as the food standards agency and staff numbers being cut by 45%. This increased unemployment and had the knock-on effect of fewer restaurants being checked for water and food quality. Due to the context of weak economic growth, those made redundant might have found it harder to find new jobs as few new jobs would be created at that time.

However, this effect depends on the type of government spending being cut. If you cut pension spending, for example by increasing the pension age, this may even increase employment as people may need additional income to compensate for the loss in pension income they receive A greater number of workers would then be paying income tax which can again help reduce government budget deficit. Hence the government may cut pensions and benefits to decrease the budget deficit Furthermore, the government may be able to cut spending in areas of inefficiency for example, a state-owned firm may be more concerned about the political implications of making people redundant than getting rid of surplus workers. This is a type of X-inefficiency. Hence, if they were able to remove the inefficient workers, the government would save more money and make the industry more efficient.

Secondly, the government can attempt to reduce a significant budget deficit by increasing taxes. By increasing taxes, the government will have more revenue and budget deficit will be reduced

However, the likely impact of this type of austerity would be a decrease in investment and consumption therefore leading to an inward shift of the AD curve (as shown in the first diagram below). This is because higher taxes more likely means that businesses and foreign companies would be less willing to invest/move their companies to the UK due to being taxed a greater amount. This will likely also stunt long run economic growth. This is shown in the second diagram below in which there is an inward shift of the UK’s PPF due to a loss of investment and therefore less productive capacity.

However, this may not be the case. By being fiscally responsible, the government might encourage investment as it gives investors greater confidence about the long-term performance of the economy. If the national debt grows too large investors can be discouraged to invest as they may believe that the economy may be unstable in the future as the government has to pay off its debt and growth is depressed by large interest payments. Additionally, lower debt levels will encourage the private sector to invest as the amount of risk involved would have decreased, therefore further contributing to overall greater confidence. By reducing the budget deficit, the government encourages confidence in the economy which in turn stimulates growth as consumers and businesses would have greater confidence to borrow and invest/spend. A government attempting to reduce a significant budget deficit is beneficial in the long run as it reduces the cost of bond yields. Bond yields are the interest rate paid on government gilts or bonds. If bond yields were to remain high, it can cause a reduction in the amount of private investment an economy receives further weakening economic growth. Additionally, cutting budget deficits will give investors greater confidence about the long-term performance of the economy.

Even though in the short run attempting to reduce a significant budget deficit can lead to unemployment due to the government reducing spending in different sectors further weakening economic growth, austerity is worthwhile due to the long-run benefits as it is more beneficial overall to boost investor confidence for the long-term performance of the economy.

Essay 7: Lottie Payne

Evaluate the likely positive impacts of a recession on a developed country.

A recession refers to when there is a fall in GDP for two or more consecutive quarters, and its impact on a country's economy is often very negative. For example, very famously the 2008 financial crisis pushed almost all the world's largest economies into a recession; the impacts of which lasted long after 2008, prompting the UK austerity measures that were used to balance the government budget after the borrowing costs incurred during the crash, which lasted over 10 years since the initial crash in 2008 and had devastating impacts on many people in the U.K. However, whilst a recession has many negative impacts for a country’s economy and the people that live within in, not all of the effects have to be negative. For example, a crash in housing prices can often help people to get onto the property ladder and it may prompt much needed structural changes to be made in the economy This and the other points I will be discussing show how not all of the impacts of a recession are negative.

During a recession, housing market crashes can allow people to get onto the property ladder when they otherwise wouldn’t have been able to. For example, in the 2008 financial crash the USA’s housing market crashed and many people were left being forced to default on their mortgages and sell and at a lower price. Those with existing savings who previously had been unable to get onto the property ladder due to prices being artificially high were now able to purchase a house as house prices were lower due to an increased supply. This could be considered a natural adjustment to the housing market as house price speculation may have pushed prices up artificially prior to the crash. I addition interest rates were coming down making mortgages more affordable. The Central Bank uses monetary policy to attempt to encourage people to spend not save in order to boost the economic growth. Lowering interest rates encourage firms and consumers to spend and invest

Following the 2008 financial crash interest rates in the US fell to as low as 0.5% in 2009. As a result, consumers previously unable to afford a mortgage at higher interest rates were now able to get onto the property ladder.

However, this is a case of winners and losers in a recession. Whilst some benefit from falling house prices allowing them to climb the property ladder it is that may others had been forced off it leading to greater inequality. During times of recession unemployment and mass redundancies are very common and this leads to low consumer confidence. Due to a lack job security it is likely that many more consumers were prevented from purchasing a house as they lacked the security needed in order to commit to mortgages payments. For example, in the years following the 2008 financial crash unemployment rose 10% in the US, which shows that whilst it can be beneficial for some when house prices are low it may be detrimental to many more

Another possible positive impact of a recession is that it can lead to necessary changes in an economy's structure. A recession may force governments to realise the flaws in the existing policies that allowed a crisis like this to occur and force them to make necessary changes to prevent future problems. The 2008 financial crisis was, at least in part, caused by a lack of regulation in the banking sector. The crash led to complete overhauls of the current banking regulation to ensure such a crisis never occurred again. Schumpeter’s creative destruction theory suggests that recession can act as a signal for a complete restructuring within an economy. Inefficient firms are forced out and the strongest are left. An example of this is the development of new technology that can lead some firms to go out of business as they do not adapt to the changes and increase profits of the firms that adopt the new technology. This can be illustrated by the fact that of the top 100 companies today only 5 were in the top over a 100 years ago. Recessions can help accelerate creative destruction, so it can be argued that recession can lead to necessary long run changes in an economy

However, one issue with this is that it is partly dependent government response to the recession. Creative destruction can be very painful in the short run for the people who live in the economy as firms go out of business and people are left unemployed. In times of recession governments are focused on resolving current issues. They also have limited resources especially in times of a recession when any debt they accumulated before price has greatly increased borrowing costs can increase. Governments may obstruct creative destruction by subsidising inefficient firms in order to protect jobs. They may bail out or nationalise inefficient firms in order to help them survive in the short-run only to be saddled with the long-run costs in the long-run. This shows that any long-run positive benefit of a recession via creative destruction is dependent on the government and its policies.

In conclusion whilst recessions may have some possible positive impacts it overall is better for them to be avoided as the negative impacts greatly outweigh the possible benefits as recession tends to lead to unemployment, homelessness, the devaluation of people’s live savings, loss of business and consumer confidence and governments running up debt that may take decades to repay. However, if unavoidable there are some possible positive impacts that can be targeted.

Essay 8: Declan Teevan

Evaluate the economic conditions under which an aggressive monetary stimulus will be most effective.

Monetary stimulus refers to changes in monetary policy designed to increase aggregate demand. This is typically done through measures such as adjusting interest rates or quantitative easing. Deflation is when there are sustained average falling prices in an economy. Stagnation is when an economy is suffering from slow or no economic growth. Quantitative easing is when the central bank increases the money supply in order to influence aggregate demand.

During the 2000s, Japan suffered from a period of economic stagnation and sustained deflation, shown in the diagram below by the shift in AD from AD1 to AD2 and the consequent falling price levels of PL1 to PL2. Under these deflationary economic conditions, the prime minister of Japan in 2015, Shinzo Abe, implemented an aggressive monetary stimulus strategy, now known as Abenomics, which focused on increasing aggregate demand through quantitative easing. The Bank of Japan printed more money, which was then sold as bonds to the banks in Japan. Due to the banks now being flushed with money from these bonds, it led to the banks lowering their interest rates and loaning out this money. As a result, this led to a decrease in the cost of borrowing, leading to an increase in consumption and investment, which caused an outward shift in aggregate demand. This is represented in the diagram below as the shift from AD2 to AD3. This shift in aggregate demand led to an increase in price levels, from PL2 to PL3, therefore solving Japan’s deflation problem, in addition to fuelling economic growth in the country, with real GDP increasing from Y2 to Y3, successfully taking the country out of their cycle of economic downturn.

However, time lags are the time it takes for policies implemented by the government to take effect. Although an aggressive monetary stimulus policy utilising quantitative easing was successful in Japan, it may not always be entirely effective in every situation. Quantitative easing is a timely process and therefore there could be time lags. By the time that quantitative easing starts to take effect, from when the government started the process of quantitative easing and when the banks began to lower their interest rates and loan out the money, it may bring no benefit to helping solve the country’s economic problems, as the economic conditions of the country may have completely changed. For example, the central bank may have started quantitative easing in order to help the country out of an economic downturn caused by deflation, but by the time it begins to take effect the country is instead beginning to experience inflation, and the quantitative easing instead fuels that problem further by causing an increase in aggregate demand, which would cause an increase in the price levels, further adding to the inflation and worsening the country’s economic conditions.

Interest rates are the reward for saving and the cost of borrowing. An output gap is the difference between real GDP and potential GDP. A recessionary output gap is when the real GDP is lower than the potential GDP. Under economic conditions where there is a recessionary output gap, a government may find aggressive monetary stimulus effective for helping to improve the economy. For example, a country may have high interest rates, which will make saving money more attractive to consumers, increasing their marginal propensity to save. Firms will be less willing to take out loans due to having higher interest payments. As a result of consumers saving more, as opposed to buying goods and services, business confidence may decrease. Due to this, consumption and investment will decrease which will cause an inward shift of aggregate demand, from AD1 to AD2, leading to a decrease in the country’s GDP, from Yp to Y1, creating a recessionary output gap. In order to solve this problem, the Central Bank may implement a policy of aggressive monetary stimulus and decrease their interest rates. By decreasing interest rates, consumers will be less willing to save their money and will instead spend their money on purchasing goods and services, leading to an increase in consumption. Lower interest rates will also make it more attractive for firms to take out loans, leading to an increase in investment. This increase in consumption and investment will lead to an outward shift in aggregate demand, from AD2 to AD1, increasing the country’s GDP from Y1 back to Yp, closing the negative output gap and taking the country out of economic downturn.

However, financial capital flight occurs when large sums of money are taken out of the country by firms or investors. A liquidity trap occurs during a period of very low interest rates and a high amount of cash balances held by households and businesses fail to stimulate aggregate demand. By lowering interest rates, the government may end up causing financial capital flight. If the Central Bank continually lowers the interest rate, businesses and investors may choose to move their money to other countries where they can earn more interest from their investments. As a result of this, it may lead to further decreased consumer and business confidence, which will cause an inward shift of aggregate demand leading to worse economic conditions as a result. In addition to this, the government may not benefit from lowering the interest rate at all, as they may run into a liquidity trap. For example, if the government currently has the interest rate at a low 1%, then lowering it further to 0.5% is not likely to encourage consumers or firms to spend more, as the interest rate is already low enough. Therefore, there will be little to no impact on consumption and no outward shift of the aggregate demand curve, bringing no benefit to helping the country out of its economic downturn and instead encouraging additional financial capital flight which would cause more damage to the economy.

In judgement, I believe that monetary stimulus can be very effective at helping to solve an economic downturn, but only under the right conditions. For example, monetary stimulus can be helpful under conditions where the economy is affected from the demand side, such as experiencing low consumer and business confidence like Japan did in the 2000s. However, an aggressive monetary stimulus will not be very effective at helping when an economic downturn is the result of issues from the supply-side of an economy, such as a country having low productivity levels of their workforce relative to other countries, as monetary policy focuses on influencing aggregate demand, not aggregate supply. Instead, an aggressive supply-side market-based stimulus or an aggressive supplyside interventionist approach should be used to help solve an economic downturn under those conditions. If an economy is suffering from conditions where there is high inflation and stagnation, known as stagflation, then a combination of a monetary stimulus and supply-side policies may be best to help solve the economic downturn.

Essay 9: Matthew Jones

Evaluate the effectiveness of the UK’s monetary policy in improving the performance of the UK economy since 2008.

Monetary policy is when the monetary authority of a nation changes the interest rates or money supply in order to affect consumers and businesses spending in an economy. This will influence the cost to borrow and creates a better return on saving. Quantitative easing is part of monetary policy which is "the use of the money supply to affect AD". Monetary policy is used to affect the inflation rate of the economy and in the UK the target the Bank of England has set for inflation is 2% with a give of 1% each way.

One example of how the Bank of England used monetary policy in response to the 2008 financial crash was through lowering interest rates. As economic growth was very slow during the recession and inflation pressures rising, they cut interest rates from 5% to 0.5% in 2009. In this way, monetary policy was used to help the UK recover from recession as it encouraged consumers to borrow to spend by lowering interest rates as they would get less of a return on saving. In addition, businesses will be less likely to invest as the cost of borrowing has increased. Consumption and investment are both components of aggregate demand.

The diagram above shows the effect of lowering interest rates. Originally the economy is suffering from a negative output gap ay Y1, P1. The lowering of interest rates causes AD to shift from AD1 to AD2, causing the price level to rise from P1 to P2 and Real GDP to rise from Y1 to Y2. This expansionary effect is caused by the increase in consumer spending and investment in the economy, boosted by the multiplier effect, thus generating more output and getting the economy closer to the YFE point of full employment.

On the other hand, UK monetary policy may not have been fully effective. Liquidity traps exist when people decided to hoard money rather than spend it. This happens when interest rates are so low consumers and investors don’t want to put money into bonds or other debt instruments. This term was first used by John Maynard Keynes, where he believed that people will rather put their money into savings accounts as they think that interest rates will rise in the future, making bond prices fall and would therefore be a less desirable option; not only bonds but spending on goods and services as well. For example, between 2009 to 2016 the UK interest rates stayed at 0.5% because if interest rates were to drop further there would be minimal effect, provoking no new investment. Therefore, liquidity traps expose one limit to the effectiveness of monetary policy.

Quantitative easing is the introduction of new money into the money supply by a central bank. This involves the injection of money into the economy. The Bank of England's policy for quantitative easing, started in March 2009. The Monetary Policy Committee (MPC) of the Bank of England authorised the purchase of £200 billion worth of assets, mostly government debt or ‘gilts’. In October 2011 there was another purchase of £75 billion and further in February 2012 the committee decided to buy an additional £50 billion. By July the MPC decided to yet again purchase a further £50 billion, bringing total assets to £375 billion. Over the decade the total purchases came to £435bn by 2019. This was implemented because as the Bank of England injects money into financial institutions via buying up their binds/gilts, the financial institutions will be more likely to lend and inject the money into the circular flow to boost economic growth. However, this was made more difficult due to demand-pull inflation, which occurs when aggregate demand grows more than aggregate supply, increasing the price level. Inflation is the general rise in price of goods in an economy which will cause upwards pressure on prices due to shortages in supply or an increase in demand. In 2010 the CPI measure inflation rate rose to 4.61% and increased further to 5.2% in 2011, over double the Bank of England's target of 2% (plus or minus 1%). This rise in inflation disincentivises consumer spending, negatively impacting the GDP. On top of this, it will also affect firms as they will have increased costs, resulting in additional higher price. As a result, they might make workers redundant to reduce these costs so that they can be more competitive to stay afloat. The existence of relatively high inflation might suggest that the UK’s monetary policy after the financial crash was overly aggressive and therefore not suitably effective.

In judgement, since 2009, the UK economy has used monetary policy to help the economy recover from the financial crash. However, as well as monetary policy the UK government implemented expansionary fiscal policy to help improve the economy. An example of this would be the temporary 2.5 percentage point cut in the VAT rate. This will make goods cheaper for consumers so that it is easier for low-income earners to buy essentials, increasing the incentive to spend. Therefore, it is not possible to say whether the recovery was due to monetary policy or fiscal policy, and it was most likely the result of both policies working together