CC6 - performance and policies

What is the main functions of bank of England

issue of currency

management of government debt

operation of monetary policy

regulation of financial system

ensuring financial stability

The monetary policy committee (MPC)

meets at the bank of England. It is chaired by the governor of the bank

there are 9 members ( 5 from bank and 4 independent)

publishes the minutes of its meeting 8 times a year

if the inflation target of 2% is missed the governor must send an open letter to the chancellor

More on MPC

each member has expertise in the field of economics and monetary policy

members do not represent individual groups or areas. They are independent

each member has a vote to set interest rates at the level they believe is consistent with the meeting the inflation target

The banks remit and inflation target

the inflation target is 2% CPI inflation ( target announced each year)

in extreme circumstances the government could instruct the bank for a limited period

if the target is missed by 1% or higher ,either side of the target,then the governor has to write an open letter to the chancellor explaining why the target has been missed and what can be done to get back to target

how does monetary policy work?

bank of England controls inflation by implementing contractionary or expansionary monetary policy

when MPC changes the official interest rate called the bank rate…

it is aiming to influence the level of aggregate demand in the economy

Bank rate

the rate that the bank pays on the reserves held by commercial (high street) banks at the bank.

When this changes it is a signal for all other borrowing and lending rates in the economy to change

when the bank rate rises..

all other interest rates (for saving,lending and borrowing) should rise

vice versa for when the bank rate falls

Contractionary monetary policy

if inflation is moving above target then the bank rate will be increase

effects of a rise in interest rates on consumer spending

consumer spending will fall

savings more attractive

mortgage repayments are higher

borrowing more expensive

effects of a rise in interest rates on investment

investment will fall

more costly borrowing

fewer projects worthwhile at higher costs

effect of a rise in interest rates on the demand for exports and imports

rise in the uk interest rates will attract saving or hot money to uk banks

demand for pound will therefore increase

value of pound will increase

price of exports will increase therefore demand for exports fall

the price of imports will fall therefore the demand for imports will rise.

a rise in the value of the pound will casue a worsening of the current account balance (i.e larger current account deficit)

the effect of rising interest rates of aggregate demand

consumer spending will fall

investment will fall

the value of exports will rise

value of imports will rise Therefore AD is likely to fall and inflation will fall

what does the effect on consumers depend on?

Higher interest rates affect people in different ways: The effect of high interest rates does not affect each consumer equally.Those consumers with large mortgages (often first time buyers) will be disproportionally affected by rising interest rates.

Time lags: The effect of rising interest rates can often take up to 18 months to have an effect.e.g if you have an investment project 50% completed,you are likely to finish it off.However the higher interest rates may discourage starting a new project in the next year.

It depends upon other variables in the economy: at times ,a rise in interest rates may have less impact on reducing the growth of consumer spending.E.g if house prices continue to rise very quickly,people may feel that there is a real incentive to keep spending despite the increase in interest rates.

what does the effect on investment depend on?

Time lags-if a firm has started an investment project,a rise in interest rates will be unlikely to change the decision.The firm will continue to finish the investment.However it will make them think twice about future investment projects.Therefore changes in interest rates can take time to have an effect

Other factors- interest rates can be outweighed by economic conditions.E.g in 2009 interest rates were cut from 5% to 0.5% - but investment fell because of the deep recession and the willingness of the banks to lend. it was cheap to borrow,but in these circumstances this wasn’t enough investment

Fixed interest loans- Some firms may fix their interest rates on borrowing so raising interest rates will have a little effect on their current borrowing costs

what does the effect on exchange rate of currency depend on?

determined by a range of factors such as interest rates,confidence,the current account balance of payments,economic growth and relative inflation rates E.g if uk business became relatively more competitive ,there would be greater demand for uk goods;this increase in demand for uk goods would cause an appreciation of the pound

However,if markets were worried about future of the uk economy they would tend to sell pounds ,leading to a fall in the value of the pound

expansionary monetary policy

to stimulate aggregate demand if inflation is expected to move below target would usually involve a cut in the bank rate

how would a cut in bank rate lead to a rise in aggregate demand?

all other interest rates in the economy will fall

saving will become less attractive compared to spending

borrowing will become cheaper so the demand for consumer durables will rise

mortgage interest will fall leading to a rise in the demand for houses and a rise in house prices

higher house prices might casue a positive wealth effect

the demand for business borrowing and investment will rise

external value of the pound will fall

the level of exports will rise

what is the interest rate transmission mechanism

it summarises the effects of changes in the bank rate on the economy and the rate of inflation

cel Economics Revision

drawback of interest rate changes in terms of time

the bank estimates that it takes between 18 months to 2 years for a change in the bank rate to have its full effect on the economy

quantitative easing

the bank of england electronically creates money and uses this to purchase assets

what is one example of QE

the bank of england increased the money supply by £200 billion on thursday 19th march 2020 following the coronavirus pandemic

is this the same as printing money

bank of england doesnt necessarily need to print more money only a very small % money in the uk economy is in notes and coins

why has this policy been used?

creates money in order to increase aggregate demand in order to keep inflation rate at 2% and prevent deep recession and deflation

what assets have been purchased?

£895 billion of bonds sicne 2008-9 government bonds and corporate bonds they stooped at the end of 2021

what is a government bond?

if the governemnt wishes to spend more than they raise then they can sell binds. the bondholder receives a rate of return on these assets.

what happens to interest rate is price of bonds goes up?

interest rate will fall as the amount payable on the maturity date will remain the same therefore there in an inverse relationship between price of the bond and the interest rate

quantitative tightening

bank of england can reduce money supply by selling their bonds to private sectors

the money used to buy these bonds are withdrawn from the economy by the bank of england

what is the goal?

to reduce the amount of money circulation and to increase market interest

this can help slow doown inflation and to correct inbalances in the economy such as overheated housing market

can also reduce the amount of credit available in the economy and can lead to a contraction in the economy activity

how does qe work?

increased cash for those who sell the assets

• individuals or firms who sell bonds to bank of England will gain cash from selling

• as the demand for bonds rises the price of bonds rise and investors can sell them for profit

• may provide more funds for businesses to invest and more funds for banks to lend

Higher prices of other assets

• as the bank of england buys binds the price of bonds rises and the interest rate on the bonds will fall therefore investors may look to buy other assets instead.This caused a rise in demand for shares and a rise in the value of shafres on the stock market

how will it affect interest rates?

lower long term interest rates

if the bank of england buys government bonds the price of the bonds will rise and the interest rate on the bonds will fall.this will reduce long term market interest rates as the commercial banks will be able to offer lower interest rates to savers because there is less competition for savings from the government which would also lead to lower rates of interest for borrowers

How would a fall in long term interest rates affect consumption and investment?

a fall in long term interest rates will reduce the incentive to save and increase the incentive to borrow this will cause increase in consumption and investment.

how will it affect the value of the pound?

if there is an increase in the money supply this is likely to reduce interest rates interest rates

international savings or hot money is attracted abroad where the return is higher.The demand for the pound will decrease and supply of the pound will increase leading toa fall int he value of the pound

how is this beneficial to the uk?

a fall in the value of the pound will casue the price of exports to fall and demand of exprots will increase

demand for imports will increase and demand will decrease

effect on output and inflation

contributed to higher growth and inflation

effect on borrowing

made it much easier and cheaper for governemnts to borrow

why has QE been damaging to savers and pensioners

has reduced the interest rates on savings accounts and reduced the incomes for pensioners and other individuals who rely on interest as an important source of income

why could QE create greater inequality?

qe has increased a rise in assets prices such as shares and houses this has increased wealth inequality as the rich tend to own shares and valuable properties

why could a rise in share prices create macro economic instability?

share prices will inevitably crash in the long run and this causes a negative wealth effect which reduces AD and GDP

Fiscal Policy

the manipulation of governemnt spending and taxation to change aggregate demand and achieve macroeconomic objectives

The bidget

the annual statement of planned spending and tax revenue

budget decifit

when government spending exceeds tax revenue

budget surplus

when tax revenue exceeds governemnt spending

what is the top 3 areas of government spending?

1. social protection

2. health

3. education

income tax

a tax on the income of individuals

national insurance contribution

tax on labour,paid by both employees and employers

corporation tax

tax on company profit

capital gains tax

tax on capital gains e.g the difference between the buying price and selling price of an asset like shares

inheritance tax

tax on value of assets left on death

excise duties

taxes levied on a narrow range of goods e.g vehicle fuel ,alcohol,tobacco

value added tax

tax on expenditure currently 20%

council tax

tax imposed on domesztic property by council based on estimated sale value in 1992

business tax

a local authority tax on business property based on estimate of reasonable yearly rent

what are the top 3 revenue raisers in the uk

1. income tax

2. vat

3. national insurance contribution

direct tax

levied on income ,wealth and profit these taxes are imposed directly on an individual or organisation

indirect tax

levied on spending by consumers on goods and servies they are imposed on suppliers who may pass on the cost to consumers by rainsing prices therefore pay the taxes indirectly

describe the change in government borrowing from 1993n to 2020

it has fluctuated but there is trend of government budget

why did the budget deficit increased in 2020/1

during covid gevoernemnt had to spnd lots of monet

national debt

totla outstanding debt that has accumulated overtime in years when there is a budget deficit the national debt grows

how does government spendng affect AD

it is a component of AD

a rise will lead to a rise in AD and natinal income

how will taxes affect AD

a fall in taxes will casue a rise in disposable income and therefore a rise in consumer spending which is a component of AD thereofre there will be an increase in AD

how do changes in governemnt spenindg and tax affecr the economy? in temr sof circular flow of income

governemnt spenindg represents an injection into circular flow of income

taxation represents a withdraw out of the circular flow of income

a budget deficit will cause a net injection into the circular flow of income

a budget surplus will casue a net withdraw out the circular flow of income

expansionary fiscal policy

when GS > T

contractionary fiscal policy

T>GS

How will the effectioveness of fiscal policy depend on the size of the multiplier?

larger the multiplier the more eeffective the fiscal policy will be in boosting AD hence ideally need to avoid leakages

how will the impact of fiscal policy changes depend on private sector investment and consumption?

expansionary fiscal policy best when it gives more confidence to households to consume and for firms to invest

what are the costs to the governemnt of using expansionary fiscal policy to reduce unemployment?

greater budget deficit therefore higher national debt

supply side policies

set of economic measures and strategies that aim to improve the long run productive capacity and efficiency of an economy

free market or supply side economists

they believe that resources are allocated efficiently using free markets.They argue that the governemnt intervention in the economy is usually harmful and therefore support the implemetntion of market baesd policies desinged to removes barriers to the efficient working of free markets

interventionist eonomists

they beleive that free markets often fail to allocate resources efficienlty therefore governemnt shoudl intervene to correct market failure

market based supply side policies

these policies emphasises minimal government intervention and regulation while promoting individual initiative and entreoeneurship and competition

policies to increase incentives

reducing income tax rates

what would be the effect of raising the personal allowance

higher incentive to enter labour market

what are the potential problems with cutting inocme tax rates

workets who dont receive overtime payments cannot respind to changes in marginal tax rates except for leaving workforce

why would you think the government decided to freezr personal allowance in 2023 bidget

aimed to help raise revenue for governemnt becuase as incomes rise individuals pay a higher % of income in tax

policies to increase incentives

reducing corporation tax

corporation tax is levied on company profits between 2010 and 2022 the corporation tax e=rate was cut from 28% to 19% how could this affect AD

higher revenue therefore higher investment

what are the potential problems

lower tax revenue

why did the governemnt decide to rasie corporation tax?

tax cut didnt work in increasing investment by firms and government is desperate for more tax revenues