Explain how the monetary policy transmission mechanism works when the Monetary
Policy Committee (MPC) raises Bank Rate.
When the Monetary Policy Committee (MPC) decides to raise the Bank Rate, it aims to tighten monetary policy and control inflation. The transmission mechanism explains how this policy action affects the broader economy. Here's an overview of the monetary policy transmission mechanism when the MPC raises the Bank Rate:
Commercial Banks: The change in the Bank Rate directly affects the interest rates commercial banks charge on loans and pay on deposits. When the Bank Rate increases, commercial banks are likely to raise their lending rates, making borrowing more expensive for businesses and individuals. This reduces the demand for loans and can slow down investment and consumption.
Borrowing Costs: Higher lending rates have an impact on various forms of borrowing, including mortgages, personal loans, and corporate borrowing. As interest rates rise, the cost of servicing existing debt increases, which can put financial strain on borrowers and reduce their spending capacity.
Consumption and Investment: Higher borrowing costs and reduced access to credit can discourage consumer spending and business investment. Individuals may cut back on discretionary purchases, leading to lower retail sales. Similarly, businesses may delay or reduce their investment plans, which can have a negative impact on economic growth.
Aggregate Demand: The decline in consumer spending and business investment, resulting from higher borrowing costs, can lead to a decrease in aggregate demand. This reduction in demand can contribute to a slowdown in economic activity and potentially dampen inflationary pressures.
Price Levels: The tightening of monetary policy through an increase in the Bank Rate aims to control inflation. Higher borrowing costs can reduce consumer spending, which may moderate price increases and help keep inflation in check. By curbing demand, the policy action can alleviate inflationary pressures in the economy.
Exchange Rates: A change in interest rates can also affect exchange rates. If the Bank Rate increases, it can make the currency more attractive to investors seeking higher returns. This increased demand for the currency can lead to an appreciation, making exports relatively more expensive and imports cheaper. This, in turn, can impact the trade balance and competitiveness of domestic industries.
It's important to note that the transmission mechanism is not instantaneous, and the full effects of a change in the Bank Rate take time to filter through the economy. The responsiveness of the transmission mechanism can vary depending on factors such as the financial system's health, the level of household and corporate debt, and the overall economic conditions.
In summary, when the MPC raises the Bank Rate, it influences borrowing costs, which can affect consumption, investment, aggregate demand, price levels, and exchange rates. The overall impact on the economy depends on how businesses, households, and financial markets respond to the change in interest rates.
Evaluate the view that the main objectives of UK government macroeconomic policy can
be achieved without conflicting with each other.
The main objectives of UK government macroeconomic policy typically include promoting economic growth, maintaining price stability (low inflation), reducing unemployment, and ensuring a sustainable balance of payments. While these objectives are interconnected, there can be instances where they may conflict with each other to some extent. Let's evaluate the view that these objectives can be achieved without conflicting:
Economic Growth and Price Stability: Economic growth is desirable as it leads to increased output, employment, and living standards. However, sustained high economic growth can put upward pressure on prices, potentially leading to inflation. Central banks often aim to maintain price stability by implementing monetary policies, such as adjusting interest rates, to control inflation. In this regard, achieving both high economic growth and low inflation simultaneously can be challenging and may require a careful balancing act.
Unemployment and Price Stability: Lowering unemployment is a crucial macroeconomic objective to improve living standards and reduce social costs. However, policies aimed at reducing unemployment, such as expansionary fiscal or monetary measures, can stimulate aggregate demand, potentially leading to inflationary pressures. Again, striking a balance between reducing unemployment and maintaining price stability can be complex.
Balance of Payments and Economic Growth: The balance of payments reflects the inflow and outflow of goods, services, and capital in an economy. While a sustainable balance of payments is desirable, policies aimed at achieving a favorable balance, such as export promotion or import restrictions, may have an impact on economic growth. Restrictive trade measures can limit access to foreign markets and potentially hinder economic growth opportunities.
While there can be instances where achieving these objectives may present trade-offs or conflicts, it's important to note that they are not necessarily mutually exclusive. Effective macroeconomic policies and strategies can strike a balance between these objectives to minimize conflicts and maximize overall economic performance. For example, implementing structural reforms to enhance productivity and competitiveness can contribute to both economic growth and job creation. Similarly, well-designed fiscal policies can stimulate economic activity without leading to excessive inflationary pressures.
Moreover, a stable macroeconomic environment characterized by low inflation, sound fiscal policies, and effective monetary management can provide a solid foundation for sustained economic growth and improved living standards. Additionally, long-term economic growth can help address structural issues, reduce unemployment, and contribute to a sustainable balance of payments.
In conclusion, while there may be instances where the objectives of UK government macroeconomic policy present challenges and potential conflicts, it is possible to pursue them in a complementary manner through well-designed policies, targeted interventions, and a holistic approach to economic management. Achieving a balance between these objectives requires careful analysis, effective policy coordination, and a long-term perspective to promote stable and sustainable economic growth.
To what extent do you agree that a fall in savings is beneficial for the UK economy?
Justify your answer.
Savings: In economics, savings refer to the portion of income that is not consumed but set aside for future use. It represents the act of saving money or assets for future needs or investments rather than spending them immediately. Savings can take various forms, including depositing money in a bank account, purchasing financial assets, or investing in physical assets.
Beneficial for the UK economy: Savings play a crucial role in the overall health and stability of an economy, including the UK economy. Here are some reasons why savings are considered beneficial:
Investment and capital formation: Savings provide the necessary funds for investment in the economy. When individuals and businesses save, those savings can be channeled into productive investments, such as building infrastructure, expanding businesses, or conducting research and development. These investments contribute to economic growth, job creation, and technological advancement.
Economic stability: A healthy level of savings helps create a stable economic environment. Savings serve as a buffer during economic downturns or unexpected events, providing individuals and businesses with the financial resources to weather challenging times. It helps mitigate the impact of income fluctuations, reduces reliance on debt, and supports economic resilience.
Financing government expenditure: Governments often rely on savings in the form of tax revenues and borrowing from individuals and institutions to finance public expenditure. Adequate savings can support government initiatives, such as infrastructure development, social welfare programs, and investment in public goods and services.
Capital accumulation: Savings contribute to the accumulation of capital in an economy, which is essential for long-term economic growth. Capital accumulation involves acquiring physical and human capital, such as machinery, equipment, technology, and skills. It enhances productivity, innovation, and the competitiveness of industries, leading to higher living standards and economic prosperity.
To what extent do you agree that a fall in savings is beneficial for the UK economy?
The statement that a fall in savings is beneficial for the UK economy is not generally supported. Here's why:
Investment constraints: A decline in savings can limit the availability of funds for investment in the economy. Insufficient savings can lead to reduced investment levels, hampering productivity growth, innovation, and long-term economic development.
Financial vulnerability: A significant decrease in savings can increase financial vulnerability for individuals and businesses. It leaves them with limited financial buffers to cope with unforeseen circumstances, such as job loss, medical emergencies, or economic downturns. This can result in increased household and corporate debt levels, which can pose risks to financial stability.
Retirement and future planning: Declining savings can have adverse effects on retirement planning and long-term financial security. Inadequate savings may result in individuals not having enough funds to support themselves during their retirement years, increasing reliance on government social welfare programs.
Economic imbalances: A fall in savings can contribute to imbalances in the economy, such as excessive consumer borrowing or overreliance on foreign capital inflows. These imbalances can lead to unsustainable levels of debt, asset price bubbles, and macroeconomic instability.
It is worth noting that the optimal level of savings depends on various factors, including the specific circumstances of the economy and the stage of economic development. While excessive saving can lead to underconsumption and hinder economic growth, a sharp decline in savings can have negative consequences as well. Striking a balance between savings, investment, and consumption is crucial for sustainable economic development and financial well-being.
Explain the process by which neo-classical economists argue that the economy can
adjust to long-run equilibrium following a negative demand side shock. Use a diagram to
support your answer.
In response to a negative demand-side shock, an economy can adjust through various mechanisms. Here's a simplified explanation of the adjustment process:
Decreased Demand: A negative demand-side shock occurs when there is a reduction in overall demand for goods and services in the economy. This can happen due to factors such as a decline in consumer spending, investment, or exports.
Reduced Output and Employment: As demand decreases, businesses experience a decline in sales and may respond by reducing production. This can lead to lower output levels and potentially result in layoffs or reduced hiring, leading to higher unemployment.
Price Adjustments: In response to the reduced demand, businesses may lower prices to stimulate demand and attract customers. Lower prices can incentivize consumers to spend more, which helps increase aggregate demand.
Resource Reallocation: The adjustment process may also involve resource reallocation. Industries or sectors that were more severely affected by the demand shock may reduce their production and reallocate resources to areas with relatively higher demand.
Wage and Price Flexibility: Neo-classical economists emphasize the role of wage and price flexibility in the adjustment process. They argue that in a flexible labor market, wages can adjust downward, allowing firms to reduce labor costs and adjust production levels accordingly.
Market Rebalancing: Over time, as prices and wages adjust, the economy moves towards a new equilibrium. Lower prices and wages make goods and services more affordable, stimulating demand. As demand starts to recover, firms increase production, leading to a gradual adjustment and stabilization of the economy.
It's important to note that the adjustment process can vary in speed and effectiveness depending on the specific circumstances, market conditions, and policy responses. Additionally, the adjustment process may be influenced by factors such as the level of government intervention, the presence of rigidities in the labor market, and the availability of fiscal and monetary policy measures to support the economy during the adjustment period.
Explain why it may be difficult for governments to achieve their macroeconomic policy
objectives at the same time.
When governments set macroeconomic policy objectives, such as controlling inflation, promoting economic growth, and reducing unemployment, it can be challenging to achieve all these goals simultaneously. There are several reasons why this is the case:
Trade-Offs: Macroeconomic objectives often involve trade-offs, where pursuing one objective may come at the expense of another. For example, implementing expansionary fiscal policies, such as increasing government spending or cutting taxes to stimulate economic growth, can put upward pressure on inflation. On the other hand, pursuing contractionary policies, like reducing government spending or increasing taxes to curb inflation, may dampen economic growth and impact employment levels. Governments need to make difficult choices to strike a balance between conflicting objectives.
Time Lags: The impact of macroeconomic policies on the economy can take time to materialize. There are often lags between the implementation of policies and their effects on variables like inflation, economic growth, and unemployment. These time lags make it challenging to fine-tune policies to achieve multiple objectives simultaneously. By the time the impact of one policy becomes evident, the economic conditions or priorities may have shifted, requiring a reassessment of policy measures.
External Factors: Macroeconomic objectives can be influenced by external factors beyond the government's control. Global economic conditions, exchange rates, geopolitical events, and changes in commodity prices can all affect a country's macroeconomic performance. For instance, an unexpected rise in oil prices can increase production costs and inflation, making it harder for the government to achieve both price stability and economic growth simultaneously.
Conflicting Policy Tools: Different macroeconomic objectives often require the use of different policy tools. For example, to stimulate economic growth, governments may implement expansionary fiscal policies, such as tax cuts or increased government spending. However, these policies can put upward pressure on inflation. To counteract inflation, policymakers may need to implement contractionary monetary policies, such as raising interest rates. But higher interest rates can also slow down economic growth. It can be challenging to coordinate and reconcile the use of various policy tools to achieve multiple objectives simultaneously.
Structural Challenges: Macroeconomic objectives can be influenced by underlying structural challenges in an economy. For instance, reducing unemployment may require addressing issues such as skill mismatches, labor market rigidities, or structural changes due to technological advancements. These structural challenges often require long-term and targeted policies beyond the scope of short-term macroeconomic measures.
To illustrate the difficulties in achieving macroeconomic policy objectives simultaneously, a relevant diagram is the Phillips curve. The Phillips curve depicts the relationship between inflation and unemployment. It suggests that there is a trade-off between these two variables in the short run, meaning that policymakers face a challenge in reducing both inflation and unemployment simultaneously.
Overall, achieving multiple macroeconomic objectives at the same time is a complex task for governments. Trade-offs, time lags, external factors, conflicting policy tools, and structural challenges all contribute to the difficulty. Policymakers need to carefully analyze and prioritize objectives based on the prevailing economic conditions and make informed decisions that consider the long-term implications of their policies.
Top Ikea executive Jesper Brodin says he is not usually one to indulge in nostalgia. But at a pre-Christmas gathering for senior managers that used to work at the Swedish furniture group, he could not help but join with the chorus of those who said they missed the old times — when the world seemed relatively stable, trends were predictable and this could be translated into a more or less credible multiyear business plan.
“We always debate whether it was better before. I used to always argue it is better now. This time we tended to agree it was better before,” he said. “The risks, the uncertainty, everything that used to be in a ‘risk matrix file’ is more or less happening . . . We laugh about the time when we were doing one-year budgets, and how we would be right or wrong by 0.3 per cent.”
Brodin’s reflections resonate across the corporate world. CEOs are struggling to make sense of confusing macroeconomic signals. In Europe and the US, an economic downturn is combined with record low unemployment and labour shortages. Consumer behaviour is a mystery: up until recently people have kept spending even though the price of almost everything has gone up.
The worst predictions of economic crisis and energy shortages from last year have not materialised. But it feels uniquely hard to predict the path ahead at the moment. On both sides of the Atlantic, little consensus is heard about where the economy is going, and for listed businesses, delivering guidance to the market is more difficult than ever. In the UK, auditing firms worry that the forecasts their corporate clients submit to them for sign-off are impossible to assess.
In the game of adjusting to these new forms of chaos, some are better placed than others. Generally pressure is less on privately owned companies that do not have to publish profit targets.
Ikea, for instance, has changed tack. Instead of setting out specific goals for the year, it has a set of “scenarios” to give the business wiggle room as the outlook changes. It means acknowledging that widely different outcomes are possible. “It’s teaching us agility in how we operate,” said Brodin.
A year ago, the 54-year-old firm expected customers to cut spending because of high energy bills and mortgage rates. That did not happen. Meanwhile, supply chain disruptions improved more quickly than anticipated, leaving the group with more inventory and, in turn, the need to lower the prices of some of its products.
“We are celebrating that things are going in the right direction,” said Brodin, “but we have no concept of predicting with precision what’s going to happen in 6 to 12 months.”
For Ikea, input costs are the trickiest to forecast. Transport prices have fallen. But Brodin did not expect that greater demand for wood to burn as fuel would make some of the company’s materials more expensive.
It is not just the traditional variables of financial modelling such as inflation and consumer spending that have become harder to predict. The past few years have also provided some unexpected lessons on how business and society cope with shocks and uncertainty.
“Look at what people have gone through: the pandemic, the economic damage, the tragedy of war, energy prices,” Brodin said. “What people might have underestimated is human resilience.”
This year has been a good one for the West. The alliance has surprised observers with its united front against Russian aggression. As authoritarian China suffers one of its weakest periods of growth since Chairman Mao, the American economy roars along. A wave of populism across rich countries, which began in 2016 with Brexit and the election of Donald Trump, looks like it may have crested.
Yet away from the world’s attention, rich democracies face a profound, slow-burning problem: weak economic growth. In the year before covid-19 advanced economies’ gdp grew by less than 2%. High-frequency measures suggest that rich-world productivity, the ultimate source of improved living standards, is at best stagnant and may be declining. Official forecasts suggest that by 2027 per-person gdp growth in the median rich country will be less than 1.5% a year. Some places, such as Canada and Switzerland, will see numbers closer to zero.
Perhaps rich countries are destined for weak growth. Many have fast-ageing populations. Once labour markets are open to women, and university education democratised, an important source of growth is exhausted. Much low-hanging technological fruit, such as the flush toilet, cars and the internet, has been plucked. This growth problem is surmountable, however. Policymakers could make it easier to trade across borders, giving globalisation a boost. They could reform planning to make it possible to build, reducing outrageous housing costs. They could welcome migrants to replace retiring workers. All of these reforms would raise the growth rate.
Growing pains
Unfortunately, economic growth has fallen out of fashion. According to our analysis of data from the Manifesto Project, which collects information on the manifestos of political parties over decades, those in the oecd, a group of mostly rich countries, are about half as focused on growth as they were in the 1980s (see chart 1). Modern politicians are less likely to extol the benefits of free markets than their predecessors, for instance. They are more likely to express anti-growth sentiments, such as positive mentions of government control over the economy.
When they do talk about growth, politicians do so in an unsophisticated manner. In 1994 a reference by Gordon Brown, Britain’s shadow chancellor, to “post neo-classical endogenous growth theory” was mocked, but it at least indicated serious engagement with the issue. Politicians such as Lyndon Johnson, Margaret Thatcher and Ronald Reagan offered policies based on a coherent theory of the relationship between individual and state. gdp’s small coterie of modern champions, such as Mr Trump and Liz Truss, offer little more than reheated Reaganism.
Apathy towards growth is not merely rhetorical. Britain hints at a wider loss of zeal. In the 1970s the average budget contained tax reforms worth 2% of gdp. By the late 2010s policies made half as much impact. A paper published in 2020 by Alberto Alesina, a late economist at Harvard University, and colleagues at the imf and Georgetown University measured the significance of structural reforms (such as changes to regulations) over time. In the 1980s and 1990s politicians in advanced economies implemented a large number, making their economies sleeker. By the 2010s, however, they had lost their oomph: reforms practically ground to a halt.
Our analysis of data from the World Bank suggests that progress has slowed still further in recent years, and may even have reversed (see chart 2). The American government introduced 12,000 new regulations in 2021, a rise on recent years. From 2010 to 2020 rich countries’ tariff restrictions imposed on imports doubled. Britain voted for and implemented Brexit. Other countries have turned against immigration. In 2007 almost 6m people, on net, migrated to rich countries. In 2019 the number was down to just 4m.
Governments have also become less friendly to new construction, whether of housing or infrastructure. A paper by Knut Are Aastveit, Bruno Albuquerque and André Anundsen, three economists, finds that American housing “supply elasticities”—ie, the extent to which construction responds to higher demand—have fallen since the housing boom of the 2000s. This is likely to reflect tougher land-use policies and more powerful nimbys. Housing construction across the rich world is about two-thirds its level in that decade.
Politicians prefer splurging the proceeds of what growth exists. Governments are spending a lot more on welfare, such as pensions and, in particular, health care. In 1979 the bottom fifth of American earners received means-tested transfers worth less than a third of their pre-tax income, according to the Congressional Budget Office. By 2018 the figure was more than two-thirds. According to a report in 2019, health spending per person in the oecd will grow at an average annual rate of 3% and reach 10% of gdp by 2030, up from 9% in 2018.
Politics is increasingly an arms race with promises of more money for health care and social protection. “Thirty or 40 years ago it was taken for granted that the elderly were not good candidates for organ transplantation, dialysis or advanced surgical procedures,” Daniel Callahan, an ethicist, has written. “That has changed.” Greater wealth has enabled this. Yet politicians rarely ask whether an extra dollar on health care is the best use of cash. Britons in their 90s receive health and social care that costs the country about £15,000 ($17,000) a year, about half Britain’s gdp per person. Must budgets rise year after year to meet growing demand, even as the price of providing that care is also likely to increase? If yes, where is the limit?
People may see spending on health care and pensions as self-evidently good. But it comes with downsides. More people work in an area where productivity gains, and therefore improvements in overall living standards, are hard to induce. Perfectly fit older people drop out of work to receive a pension. Funding this requires higher taxes or cuts elsewhere. Since the early 1980s government spending across the oecd on research and development, as a share of gdp, has fallen by about a third.
Much of the extra spending comes at times of crisis. Politicians are increasingly concerned with preventing bad things from happening to people or compensating them when they do. The enormous system of credit guarantees, eviction moratoriums and debt forgiveness introduced during the pandemic brought bankruptcies and defaults to a halt. This was radical, but also the thin end of the wedge.
In America, for instance, the federal government has assumed huge contingent liabilities. It guarantees an ever-larger quantity of people’s bank deposits; it forgives student loans; it offers a wide variety of implicit and explicit backstops to everything from airports to highways. We have previously estimated that Uncle Sam is on the hook for liabilities worth more than six times America’s gdp. This year European governments have fallen over themselves to offer financial support to households and firms during the continent’s energy crisis. Even Germany, normally Europe’s most disciplined spender, has allocated funding worth 7% of gdp for this purpose.
No one cheers when a firm goes bust or someone falls into poverty. But the bail-out state makes economies less adaptable, ultimately constraining growth by preventing resources shifting from unproductive to productive uses. Already there is evidence that fiscal help doled out during the pandemic has created more “zombie” firms—those which are going concerns, but which create little economic value. Governments’ huge implicit liabilities also mean higher spending in times of trouble, which reinforces the trend towards higher taxation.
Grey power
Why has the West turned away from growth? One possible answer relates to ageing populations. People who are not working, or are near the end of their working lives, tend to be less interested in getting richer. They will support things which directly benefit them, such as health care, but oppose those that only produce benefits after they are gone, such as immigration or homebuilding. Their turnout at elections tends to be high, so their views carry weight.
Yet Western populations have been ageing for decades, including during the reformist 1980s and 1990s. Thus the change in the environment in which policy is made may play a role. Before social media and 24-hour rolling news it was easier to implement tough reforms. The losers from a policy—a business exposed to greater competition from abroad, say—often had little choice but to suffer in silence. In 1936 Franklin Roosevelt, speaking about opponents to his New Deal, felt able to “welcome” his opponents’ hatred. Now the aggrieved have more ways to complain. As a result, policymakers have more incentive to limit the number of people who lose out, resulting in what Ben Ansell of Oxford University calls “countrywide decision by committee”.
High levels of debt have also constrained policymakers’ room for manoeuvre. Across the g7 group of rich, powerful countries, private debt has risen by the equivalent of 30 percentage points of gdp since 2000. Even small declines in cash flows could make servicing the debt harder. This means politicians quickly intervene when anything goes wrong. Their focus is keeping the show on the road—avoiding a repeat of the financial crisis of 2007-09—rather than accepting pain today as the price of a brighter future.
Quite what would push the West in a new direction is unclear. There is no sign of a shift just yet, beyond the misguided attempts of Mr Trump and Ms Truss. Would another financial crisis do the job? Will a change have to wait until the baby boomers are no longer around? Whatever the answer, until growth speeds up Western policymakers must hope their enemies continue to blunder.
