1.

Why has the UK recovery been so weak in recent years?

http://www.theguardian.com/business/2014/jan/21/imf-world-economic-recovery-outlook-weo

How is the unemployment rate measured?

The unemployed are those people able, available and willing to work at the going wage but cannot find a job despite an active search for work.

1. The Claimant Count measure includes unemployed people who are eligible to claim the Job Seeker's Allowance (JSA). The data is seasonally adjusted to take into account predictable seasonal changes in the demand for labour such as seasonal jobs in tourism, retailing, building and farming.

2. The Labour Force Survey counts those who are without any kind of job including part time work but who have looked for work in the past month and are able to start work immediately. The figure includes those people who have found a job and are waiting to start in the next two weeks. On average, the Labour Force Survey measure has exceeded the Claimant Count by about 500,000 in recent years – equivalent to 2.5% of the labour force. Because the LFS measure is a survey - albeit a large one -there will always be a sampling error in the data

http://www.economicshelp.org/macroeconomics/unemployment/measuring_unemployment/

Why is the unemployment rate usually a lagging indicator of an economic recovery?

1. Reluctance to hire: Businesses may be reluctant to hire extra workers unless they are confident that the recovery will be sufficiently strong and sustained

2. Plenty of spare capacity: After a recession, there is plenty of spare capacity, so extra output can be supplied by using existing workers and capital inputs more intensively – for example by offering the existing workforce more hours of overtime.

3. Costs of hiring and training: There are extra costs in hiring and training workers, some businesses find it a struggle to fund the expense of taking more people onto their payroll

4. Weak demand growth: If the growth of demand / output is less than the gains in output per worker then more output can be supplied with less instead of more people. E.g. output might rise by 2% but output per person employed could grow by 4%.

This is one of the most important policy issues facing not only the UK government but policy-makers in many other countries. After rising sharply over the course of the recession, the youth unemployment rate (for people under the age of 25) in the EU 27 reached 23.2 per cent of the labour force in 2013. In some countries it is more than double this. Youth unemployment rates varied from 7.7 per cent in Germany to 59.2 per cent in Greece in the summer of 2013.

What factors help to explain why youth unemployment is so high in the UK economy?

http://www.ibtimes.co.uk/bcc-urges-uk-chancellor-george-osborne-tackle-youth-unemployment-debt-uk-economic-recovery-1439569

1. Limited experience: Most younger workers have limited experience in the labour market, employers may be reluctant to hire them when older people with direct experience are in competition

2. Human Capital (skills) Deficit – many thousands of younger people leave school and college without the necessary basic qualifications and functional literacy needed to find work.

3. Reduced retirement rates limit chances – lower interest rates on savings and reduced pension incomes are causing many older workers to postpone their retirement

4. Weakness of existing training schemes – with low success rates for getting new labour market entrants into meaningful and sustained employment.

5. Limited availability of training – even when good schemes exist, young people find that there are too few opportunities to gain quality work experience.

What factors help to explain why youth unemployment is so high in the UK economy?

Analyse some of the consequences of a persistently high rate of youth unemployment

1. Social costs: Crime, Vandalism

2. Lifelong effects on future wages and earnings. It also changes the rewards from investing time and money in taking A-levels or a degree.

3. Loss of income: a decline in their real living standards and are worse off out of work.

4. Loss of potential national output and a waste of scarce labour resources

5. Young people who cannot find a job may lose the motivation to search for work, this can have a negative effect on long- run aggregate supply and damage the economy’s growth potential. This is called a “hysteresis effect”.

6. Outward migration (emigration): When unemployment is persistently high and employment rates are falling, many people may move country in search of work leading to a decline in the active labour supply. The numbers of 20-29 year-olds in Ireland fell by 8.8% 2012, as well as by 4.3% in Spain and by 3.5% in Portugal, as young people emigrated in search of work elsewhere

7. Persistently high youth unemployment is creating disaffection, social and political tensions and risks undermining support for democratic systems.

Which policies might be effective in reducing the rate of youth unemployment?

There are many policy options – some focus on short term measures to increase the demand for younger workers. Others seek to tackle structural supply-side weaknesses and failures in the labour market:

1. Improving the quality of compulsory education and more effective career guidance for students

2. Interventions to prevent early departure from schools and colleges

3. Increasing the vocational skills of disadvantaged children through training subsidies

4. Increase the number of long-term apprenticeships for the under -25s and pay participants a training wage to improve their motivation and incentives

5. Cut the national insurance contributions paid by employers when they take on extra younger workers – this is effectively a wage subsidy

6. Policies to stimulate direct job creation such as infrastructure projects

7. Encouraging business start-ups among young people and also an expansion of social enterprises working at local level who can offer jobs and work experience

What has happened to UK unemployment in the current recovery phase?

• The data suggests that total employment has recovered since the end of the recession and that unemployment has not climbed to the heights seen in past recessions. There is also some evidence that the unemployment rate is less of a lagging indicator of the economic cycle than in the past.

• One reason why the rate of monthly job losses or redundancies has fallen could be that low interest rates have reduced the number of business failures. Some commentators have discussed the existence of “zombie companies” kept afloat by a number of years of cheaper borrowing costs and who normally have been expected to go under during a recession.

• However - UK unemployment on the LFS measure is still almost 1 million higher than before the financial crisis and economic output has yet to return to its pre-recession level. The employment rate has improved but again it remains well below pre-2007 levels.

• One consequence of weak GDP growth but rising employment is that labour productivity has fallen.

• The number of people working part time because they are unable to find a full-time job has also increased – this gives rise to the concept of under-employment and suggests that the official unemployment figures often hide some important effects of a deep recession and slow recovery.

What factors might speed up the pace of recovery in the UK economy?

1. Strong economic growth in trading partner countries especially the Euro area

2. A recovery in business and consumer optimism feeding through to higher planned spending

3. The effects of the “replacement cycle” i.e. many consumers may have put off buying a new car or a washing machine for a few years during the recession, but feel that they must now start replacing their appliances. Businesses likewise might now regard replacing capital as a priority

4. A stronger than expected rise in house prices bringing about a rise in household wealth

5. Signs that the commercial banking system is expanding the supply of new credit to those wanting loans including small-to-medium sized businesses

6. An increase in UK export sales if the economy can achieve competitiveness gains such as a fall in relative unit labour costs

7. Changes to the coalition’s fiscal austerity programme – e.g. lower consumer and business taxes, slowing down the pace of fiscal deficit reduction

8. The multiplier effects of an increase in infrastructure spending by the private and public sector –there are plenty of projects to consider including HS2, the London Gateway project and Cross Rail

Why might productive capacity remain idle? How can this be measured?

Economic growth is the continuous improvement in the productive capacity to satisfy the demand for goods and services, resulting from increased production scale, and improved productivity (innovations in products and processes).

Productivity capacity is determined by the supply-side potential of an economy. This is determined by:

• The quantity of factor inputs available• Changes in total factor productivity e.g. of labour and capital• Changes to the state of technology• Business formation, improvements in the management of factor resources

Estimates are calculated by the OECD each year for the trend rate of growth of real GDP – this is perhaps the best measure of year-on-year changes in productive capacity. These estimates are shown in the next chart:

http://www.lse.co.uk/FinanceNews.asp?code=d2f75za9&headline=BoEs_Carney_says_UK_economys_spare_capacity_may_be_more_than_15_pct

How is the output gap measured? Why might it remain sizeable for an extended period?

• The output gap tells us how close current output (GDP) is to long-term potential output.

• A negative output gap is when actual GDP is less than potential GDP. Some factor resources such as labour and capital machinery are under-utilized; the main problem is likely to be higher unemployment. More people out of work indicate an excess supply of labour, which causes downward pressure on real wage rates.

• A positive output gap is when actual GDP is greater than potential GDP. Some resources including labour are likely to be working beyond their normal capacity e.g. making extra use of shift work and overtime. The main problem is likely to be an acceleration of consumer price inflation.

http://www.youtube.com/watch?v=jXZQw51UiHc

What are the problems in estimating the size of the output gap?

The output gap is the difference between actual and potential GDP. Potential output is the maximum amount of goods and services an economy can turn out when it is most efficient—that is, at full capacity. But it is difficult to get precise measures of both actual GDP and productive capacity:

1. Actual GDP might be under-recording income, spending and output – for example, the size of the shadow economy linked to non-payment of taxes, and the value of output of goods and services that don’t have a precise market value.

2. The level of potential output and, hence, the output gap cannot be observed directly.

3. The trend growth of output depends in part on how many years’ worth of data is used in the calculation. Statisticians claim that estimating the trend in a series of data such as GDP is especially difficult near the end of a sample – just at the time when the value of the estimated output gap is of most interest to policy-makers.

4. One way of measuring the amount of spare capacity in the economy is to use producer surveys. These surveys ask questions about skilled labour shortages and other factors that might be limiting production. But there is inevitably sampling error and firms may interpret questions differently.

5. The underlying structural relationships in the economy often change over time. Some industries might be in decline (heavy manufacturing for example) whilst others are rising fast (creative services, cloud computing, additive manufacturing) – but the official data on GDP by value added of output might be failing to pick these changes up accurately.

Thus it is hard for the Bank of England and others to get a precise measure for the output gap – the extent to which they rely on survey evidence and can have a big bearing on interest rate decisions.

Other measures of capacity pressure in the economy include:• Total employment• Surveys of capacity utilization• Surveys of labour shortages• Data on average hours worked and average hourly earnings

What is meant by hysteresis? What are some of the main causes of hysteresis?

• The dictionary definition of hysteresis is “the lagging of an effect behind its cause.” In mainstream macroeconomics it has become common to explain hysteresis as a tough problem caused by a deep recession and persistently high unemployment.

• For example, a long-term unemployed worker loses skills and motivation and so finds it hard to re-enter the labour force. Indeed, some “discouraged workers” may leave the labour market and become economically inactive.

• In the autumn of 2013, 8.9 million people of working age was either not looking for work or not available for work – these are the economically inactive – and this accounts for over a fifth of the population of working age in the United Kingdom.

Hysteresis can also be caused by:1. Businesses failing / closing down leaving depressed areas and regions2. Other businesses making deep cuts in investment to a level insufficient to replace worn out plant and machinery3. Commercial banks that lose money in a recession and become strict with their lending to businesses and households – leading to a significant contraction in loan finance for the business sector4. A deep recession can cause lower tax revenues which might then result in less investment in and maintenance of key public services and a fall in the quality of a nation’s infrastructure

Why might hysteresis be a result of sustained cyclical weakness?

1. When demand and output remain weak – largely because of low private sector spending –businesses are left with spare capacity and planned investment remains weak

2. If capital investment slumps. It may fall below the rate needed simply to replace obsolete machinery – the average age of the remaining capital stock will rise

3. Out-dated machinery and long term unemployment hurts a country’s global competitiveness affecting export performance and the overall balance of trade.

http://blog-imfdirect.imf.org/2012/07/19/mind-the-gap-policies-to-jump-start-growth-in-the-u-k/

Assess the possible consequences of hysteresis effects on the UK economy.

An ageing capital stock will hit labour productivity and global competitiveness:

• Persistently high unemployment contributes to a flat economic recovery – in December 2012, UK output per capita remained 14 % below its pre-crisis trend and 6 percent below its pre-crisis level

• Hysteresis effects in the labour market (linked to long term structural unemployment) will be a drain on government finances (more welfare claims and less tax revenue)

• There is the risk of human capital flight – for example a brain drain of younger (often skilled) workers who move country in search of better employment opportunities

• The loss of talented workers who cannot find employment in hysteresis-affected countries can hamper the pace of research and innovation, a country can become less dynamically efficient

• Hysteresis reduces an economy’s productive capacity and permanently depresses potential GDP

• If hysteresis contributes to higher unemployment and lower productivity it can cause an increase in the non-accelerating inflation rate of unemployment (NAIRU) making it harder to achieve price stability at a socially acceptable rate of unemployment

Identify some of the factors causing a downward trend in inflation since 2011Inflation is caused by demand-pull and cost-push factors together with the effects of administered prices and changes in inflation expectations. Having peaked at over 5% in the autumn of 2011, consumer prices inflation (CPI) has been falling since and has been dropping back towards the central 2% target. In December 2013, inflation in the UK was 2.1%.Reasons :1. Lower fuel prices as world crude oil prices have dipped – there has been a significant

slowdown in economic growth in many of the faster-growing emerging market economies

2. Continue weak growth of wages / average earnings – at a rate well below inflation

3. An appreciation in the sterling exchange rate – making import prices cheaper

4. A fall in the world prices of many commodities – for example – global wheat prices dropped 43% in the year 2013 and rubber prices have halved from mid-2011 through to the end of 2013

5. The continued large negative output gap means that the economy is operating well below capacity and there are few demand-pull inflationary pressures. Many businesses are reluctant to raise their prices when consumer demand in particular remains weak. Energy companies have appeared to be a notable exception to this!

http://www.bbc.co.uk/news/10612209

What is meant by an inflation target and why might a 2% inflation target be justified?

An inflation target is a set aim of monetary policy that seeks to keep inflation at a low positive rate. The Bank of England has a CPI inflation target, which is currently 2 per cent. The widely held view is that accelerating inflation can bring economic and social costs that are harmful for macroeconomic performance and for society as a whole. Sum of these are summarised below:

• Income redistribution: Higher inflation has a regressive effect on lower-income families and older people in society. This happen when prices for food and domestic utilities such as water and heating rises at a rapid rate.

• Falling real incomes: With millions of people facing a cut in their wages or at best a pay freeze, rising inflation leads to a fall in real incomes.

• Negative real interest rates: If interest rates on savings accounts are lower than inflation, people who rely on interest from their savings will be poorer. Real interest rates for millions of savers have been negative for at least four years

• Cost of borrowing: High inflation may also lead to higher interest rates for businesses and people needing loans and mortgages as financial markets protect themselves against rising prices and increase the cost of borrowing on short and longer-term debt. There is also pressure on the government to increase the value of the state pension and unemployment benefits and other welfare payments as the cost of living climbs higher.

• Business competitiveness: If one country has a much higher rate of inflation than others for a considerable period of time, this will make its exports less price competitive in world markets. Eventually this may show through in reduced export orders, lower profits and fewer jobs, and also in a worsening of a country’s trade balance. A fall in exports can trigger negative multiplier and accelerator effects on national income and employment.

• Business uncertainty: High and volatile inflation is not good for business confidence partly because they cannot be sure of what their costs and prices are likely to be. This uncertainty might lead to a lower level of capital investment spending.

• Risks of wage inflation: High inflation can lead to an increase in pay claims as people look to protect their real incomes. This can lead to a rise in unit labour costs and lower profits for businesses

Having a positive inflation target of 2% seeks to lock in a degree of price stability for an economy. There is an upper limit of 3% and a lower limit of 1% in part because persistent price deflation can also be a problem.

http://www.nber.org/digest/apr98/w6126.html

Identify some of the set-backs that might happen in the Euro Area

1. The economy of the Euro area might slide back into another recession without having fully recovered from the previous downturn – the recession that lasted eighteen months in the single currency area was the deepest that Europe has suffered in over forty years.

2. Another sovereign debt crisis might engulf many of the highly indebted countries inside the single currency area, especially those on the periphery of the area such as the PIIGS (Portugal, Italy, Ireland, Greece and Spain).

3. Another banking crisis such as occurred in Cyprus might erupt damaging the confidence of savers.

4. Another recession in the Euro area might bring about a period of price deflation which would be hugely costly for countries, businesses and consumers with large unpaid debt.

http://money.cnn.com/2014/01/22/news/economy/europe-economy-risks/

Distinguish between trade and financial links

• Trade links are the trade flows in goods and services between the Euro area and other countries including the UK:

o 10% of all of the imports coming into the Euro area are from the UK. 8.5% of Euro area imports come from the USA and 12% from China. So an economic downturn in the Euro area would hit exports from these countries and risk the economic recovery process in the UK and USA in particularo Over 50% of total UK merchandise trade in goods and services is with Euro area countries

• Financial links cover capital flows between the Euro area and the UK:

o Short term banking flows / foreign exchange tradingo Portfolio flows such as capital moving into and out of stock markets, property and bondso Direct capital flows such as major investment projects made by Euro area businesses in the UK and vice versao The City of London remains the euro’s main financial centre - More than 40 per cent of worldwide euro foreign-exchange is handled in London, a bigger share than the 18 countries of the euro area combined

Distinguish between public and private sector debt

• Public sector debt is owed by central and local government and by public (state-owned) corporations. The total level of accumulated public sector debt is also known as the national debt. Debts owed by state-owned banks form part of the national debt.

• Private sector debt is owed by private businesses and households. Companies may have borrowed to finance investment (corporate sector debt); households have loans for example credit card debt and mortgages on properties.

• Financial debt is also part of the private sector – this is the outstanding (unpaid) debts of banks and financial corporations - for example the level of bad debts on loans to businesses and to the housing market.

Why is a high level of private sector debt a problem for the UK economy?

1. Debt acts as a constraint on future spending power. Millions of households in the UK are saddled with many thousands of pounds of debt and the interest payments on this debt reduces their effective disposable income.

2. Banks have a high level of debt and this restricts their willingness and ability to make fresh loans to businesses and households who want to borrow.

3. The economy is at risk with such a strong debt-to-GDP ratio

a. If price deflation appeared, then falling prices and incomes would make the debt problem even worse especially in real terms .

b. If and when nominal interest rates begin to increase then a large number of households – especially mortgage payers are at risk and might struggle to make their repayments. This could cause another recession in the housing market.

http://www.debtbombshell.com/

Analyse how “commodity price volatility also remains a risk for both inflation and growth.”

1. Changes in food, metal and mineral prices affect the short run costs of many businesses – for example food processors, car manufacturers, plastics companies and transportation industries. This will lead to shifts in short-run aggregate supply (SRAS) and a change in the trade-off between growth and inflation. A rise in commodity prices for example causes an inward shift of SRAS, a rise in the general price level and a contraction in real national output (other factors remaining equal)

2. The UK economy is a net importer of many commodities. So for example, an increase in the international price of gas, rubber or coffee will cause our import bill to rise, worsening the current account of the balance of payments. And this decline in net trade will have a deflationary effect on aggregate demand.

3. Volatile prices for important commodities can also affect the incentives for exploration, research, investment and eventual supply of substitute commodities e.g. the shift towards renewable energy, lighter materials and alternatives to crude oil such as shale gas.

http://money.stackexchange.com/questions/9293/why-are-the-prices-of-some-commodities-e-g-oil-more-volatile-than-others

Identify some of the economic policies used to “bolster demand”

1. Expansionary monetary policy – including:a. Ultra low nominal interest rates (0.5%)b. Quantitative easing (QE) currently worth £375bnc. A depreciation of the exchange rated. Measures to stimulate bank lending such as funding for lending

2. Fiscal policy measuresa. Cuts in corporation tax / specific tax incentives such as lower tax rates for shale gas exploration and productionb. Increased spending on infrastructurec. Incentives for bringing private sector money into government projects

How does quantitative easing work?

• When policy interest rates are at zero or close to zero, there is a limit to what conventional use of monetary policy can do• In March 2009 the BoE started quantitative easing for first time. • The main aim of QE is to support aggregate demand and avoid a recession becoming a deflationary depression• The Bank of England uses QE to increase the supply of money in the banking system and encourage them to lend more at cheaper interest rates• The Bank does not print new £10, £20 and £50 notes instead it uses money created by the central bank to buy government bonds .

http://www.youtube.com/watch?v=rcPEkmstDek

Has quantitative easing been effective in supporting an economic recovery?

• There are doubts about the effectiveness of quantitative easing – bank lending has struggled to recover since the end of the recession. At the end of 2013, the QE programme totalled £375bn

• One effect of quantitative easing has been to reduce the interest rate (or yield) on long term government borrowing. Lower long term interest rates may have been helpful for some businesses looking to fund major investment projects using new corporate bond issues.

http://www.bbc.co.uk/news/business-24614016

To what extent are inflation expectations and nominal wage growth linked?

• Expectations of inflation are what people expect to happen to the rate of inflation in the future.• If inflationary expectations climb higher, then there might be a pick-up in pay claims so that real wages are protected

To what extent does a low wage growth and stable inflation expectations allow a further expansion of monetary policy?

•The annual growth of wages is one of the factors taken into account by the Monetary Policy Committee at their monthly meetings to determine the policy interest rate.

•If wage inflation is at moderate levels then the Bank will be less worried about the risk of cost-push inflation.

•Slow wage growth will also hold back the ability of households to spend money on goods and services.

What is meant by a “balanced budget fiscal expansion?”

This concept has become a major topic of conversation in the debate over the economic effects of fiscal austerity in many countries in the European Union and beyond. Put simply, a balanced budget fiscal expansion occurs when a change in government spending is matched by an equal change in taxation so that there is a neutral effect on the annual fiscal deficit but with the hope that real national income will expand. Central to the concept is that the fiscal multiplier effects of say a £10bn rise in government spending are higher than the negative multiplier effects of an equivalent £10bn rise in taxes.

http://www.economicshelp.org/blog/5634/economics/balanced-budget-fiscal-expansion/

What factors affect the size of the fiscal multiplier effect?

1. Design: i.e. the important choice between tax cuts or higher government spending. Evidence from the OECD is that multiplier effects of increases in spending are higher than for tax cuts or increased transfer payments.

2. Who gains from the stimulus? If tax reductions are targeted on the low paid, the chances are greater that they will spend it and spend it on UK produced goods and services.

3. Financial Stress: Uncertainty about job prospects, future income and inflation levels might make people save their tax cuts. On the other hand if consumers are finding it hard to get fresh lines of credit, they may decide to consume a high percentage of the boost to their disposable incomes

4. Temporary or permanent fiscal boost: Expectations of the future drive behaviour today ... Most people now expect taxes to rise further in the coming years. Will this prompt a higher household saving and a paring back of spending and private sector borrowing?

5. The availability of credit: If fiscal policy works in injecting fresh demand, we still need the banking system to be able to offer sufficient credit to businesses who may need to borrow to fund a rise in production (perhaps for export) and also investment in fixed capital and extra stocks.

6. The response of monetary policy: The multiplier effects of a fiscal stimulus depend in part on what happens to policy interest rates and the exchange rate (we cannot look at fiscal and monetary policy in isolation!). Would a rise in government spending and borrowing lead to higher interest rates? That might dampen the expansionary effects. Or would the Monetary Policy Committee be prepared to keep nominal interest rates low even if there were signs of stronger economic growth and recovery.

What is economic re-balancing?

Economic re-balancing describes changing the balance of demand, output and jobs in different parts of the economy. For example – attempts to achieve:

1. Re-balancing away from consumption and imports towards exports and business investment

2. Re-balancing away from dependence on the housing market towards manufacturing industry as a source of new economic wealth

3. Moving away from debt-fuelled consumer demand towards a higher level of private saving including occupational pensions and other long-term savings schemes

4. Re-balancing away from dependence on financial services towards a greater role for manufacturing and a range of emerging potentially fast-growth industries such as life sciences and creative services

5. Improving the level of regional balance i.e. encouraging more investment and jobs in areas / regions of the economy with persistently higher unemployment and lower incomes6. Re-balancing the economy away from high levels of government spending, taxation and borrowing towards a great share of national output and income flowing from the private sector

Policies to promote rebalancing

What is fiscal consolidation?

• Fiscal consolidation is a policy aimed at reducing annual government deficits and the national debt accumulation. It is also known as fiscal austerity or a tightening of fiscal policy. • The UK coalition government has a deficit-reduction policy with the emphasis on cutting government spending in real terms and a series of tax increases.

Explain what is meant by a high structural deficit?

• A structural budget (fiscal deficit) is when the government has to borrow a large amount each year even when the size of the deficit has been adjusted for the stage of the economic (business) cycle.

• In a recession, tax revenues drop and state spending on items such as welfare rises, making the deficit higher. The structural deficit adjusts for these effects.

Outline some of the key fiscal risks from a high budget deficit

When a county is running a high budget deficit some of the risks are that:

1. The Government may have to offer higher interest rates on the new debt that it issues. At the moment, the annual yield or interest rate on ten year UK government bonds is around 3%.

2. This will increase the cost of servicing debt, which for the UK government amounted to over £40bn in 2013. This interest burden has an opportunity cost for less spent on interest payments could free up financial resources for extra spending on priority public services such as health and education

3. A sizeable increase in the national debt (accumulated government borrowing) is likely to cause higher taxes in the future. This will be a drain on economic growth in the medium term because it will squeeze lower the disposable incomes of tax payers and leave less money for private sector expansion. This gives rise to what is termed “crowding out effects.”

4. It might be considered unfair if the rising tax burden falls more heavily on future generations of tax payers rather than people who benefit from government spending now.

What is meant by a bold monetary stimulus?

A bold monetary stimulus describes a combination of measures that together form an expansionary monetary policy designed to stabilise confidence, demand and output in a recession and debt-hit economy. One of the features of the handling of monetary policy in many advanced countries (including the USA and the UK) in response to the global finance crisis has been the willingness of central banks to run loose monetary policies in a bid to prevent one or more economies falling into a persistent deflationary slump.

Since 2008 in the UK we have seen:1. Policy interest rates (set by the Bank of England) drop from 5.5% in 2007 to 0.5% in March 2009 –they have stayed at that rate ever since2. The introduction of quantitative easing (QE) starting in the spring of 2009 and worth £375bn (as of Jan 2014)3. Special measures aimed at boosting the ability and willingness of the banking system to finance investment for the business sector such as Project Merlin and the Funding for Lending project4. A significant depreciation in the external value of the pound / sterling – depreciation represents a competitive boost for export sectors and for businesses in the UK that face competition from imports for the spending of domestic consumers.

Analyse how a bold monetary stimulus can help support the economy

A bold monetary stimulus is designed to:

• Support business and consumer confidence• Increase the effective disposable incomes of households with debts such as mortgages• Increase demand for interest-sensitive products such as household appliances and new vehicles• Help to bring about a depreciation in the exchange rate as hot money flows are reduced• Lower the cost of businesses borrowing money to fund their survival or investments

http://www.telegraph.co.uk/finance/comment/jeremy-warner/10691038/Has-Britains-monetary-policy-started-a-future-crisis.html

Why might a monetary stimulus have a limited effect on economic activity / recovery?A number of reasons have been put forward to explain why cutting interest rates in the aftermath of a credit crisis and deep recession may have a limited effect on economic activity (broadly defined as a recovery in real GDP and an expansion of employment, profits and investment).

1. The unwillingness of commercial banks to lend – most banks have become risk-averse and they have cut the size of their loan books and making credit harder to obtain – this has been notable for many small and medium sized businesses needing loan finance to fund their expansion / investment

2. Low consumer confidence – people are less prepared to commit to major purchases such as a new car or other household appliance because the recession has made people risk averse. Weak expectations lower the effect of rate changes on consumer demand – i.e. there is a low interest elasticity of demand.

3. Huge levels of private sector debt still need to be paid off including over £200bn on credit cards. A report from the Money Advice Service published in 2013 found that nearly nine million people across the UK are living with serious debt problems.

4. Falling or slow-rising asset prices make it unlikely that cheap mortgages will provide an immediate boost to the housing market. Property prices in much of the UK have remained fairly static until well into 2013 although London has seen very strong growth fuelled by population increases and demand from overseas investors.

5. High loan costs for some borrowers - although official policy interest rates have been close to zero since March 2009, the rate of interest charged on loans and overdrafts has actually increased –indeed it is a fact of life that the cost of borrowing using credit cards and bank loans is a high multiple of the policy rate. Much media attention has been focused on the growth of the pay-day loan industry many of whose members charge interest rates on loans well above 100% as an annual percentage rate.

6. The benefits of a weaker exchange rate have been dampened because of slow demand growth in many of the UK’s major export markets including the ongoing economic crisis in the Euro area.

Taken as a whole, when a monetary stimulus has a limited effect on economic activity / recovery then conventional monetary policy can appear to be ineffective in lifting an economy out of a deep recession. This was recognised by John Maynard Keynes in his crucial work in developing an understanding of how a collapse in private sector confidence and demand can bring about a state of almost semi-permanent recession. He developed the idea of a liquidity trap.

The Effectiveness of Monetary Policy – The Keynesian Liquidity Trap:

• In normal circumstances it is possible to boost demand by cutting interest rates. But there is a level below which interest rates cannot go and at that point monetary policy may become powerless. Moreover, even if interest rates can be lowered this may have no effect if people cannot or will not borrow. This is known as the liquidity trap.

• At this point, aggregate demand can only be boosted by the Government borrowing more, either to spend directly or to give to others via tax cuts or the like.

• In other words, we need a targeted Keynesian fiscal stimulus. Keynesians believe that the size of the fiscal multiplier effect is higher for government spending than for tax cuts.

What are the automatic fiscal stabilisers? Why do they matter?

Automatic stabilizers refer to how fiscal policy can influence the rate of GDP growth in the short term and thus help to counter swings in the business cycle.

• During phases of high GDP growth, automatic stabilizers reduce the growth rate and avoid the risks of an unsustainable boom and accelerating inflation. With higher growth, the government will receive more direct and indirect tax revenues and there will be a fall in unemployment so the government will spend less on unemployment and other welfare benefits. In some cases, a government may actually run a budget surplus during a sustained boom which acts as a net leakage of demand from the circular flow.

• In a recession, because of lower real incomes and a contraction in employment, people and businesses pay less tax, and government spending on welfare benefits will increase. The result is an automatic increase in government borrowing with the state sector injecting extra demand into the circular flow.

Recent evidence from the OECD suggests that a government allowing the fiscal automatic stabilizers to work through fully might reduce the volatility of the cycle by up to 20 per cent.

Analyse how infrastructure spending financed by temporary tax rises might cause an expansion of real GDP for a country such as the UK

The British government recognises the importance of infrastructure spending and has already published several National Infrastructure Plans with many £ billions of pounds earmarked for projects although few have yet to get off the ground or reached completion. Keep in mind too that for many of the projects mentioned below, the government is seeking a combination of public and private investment money.

Examples of infrastructure investment include:o 2nd Forth Road Bridgeo Argyll wind farm arrayo Cross Railo High Speed Rail projecto London Gateway Porto London’s new super sewero Nuclear power plants e.g. the proposed one at Hinkley Point

http://www.ibtimes.co.uk/tfl-create-1000-jobs-1bn-london-crossrail-bombardier-train-contract-1435306

The hope is the infrastructure spending creates strong multiplier effects leading to a significant effect on real GDP, employment and incomes.

• Many projects can be relatively labour intensive such as road widening, housing and environmental improvement schemes • Supply-chain businesses will benefit from producing and selling the raw materials and components needed to deliver big projects• There ought to be an accelerator effect on planned investment e.g. an increased demand for capital machinery such as earth-moving equipment

Well planned targets also have longer-run economic benefits:1. Improvements in the capacity of our transport systems

2. Stronger energy security

3. Facilitates improved geographical mobility of labour

4. Better logistics and transport systems can – in the long run – help to reduce prices for consumers

5. Greater resilience to the effects of volatile weather

6. Increased labour productivity from more efficient transport, telecommunications and logistics

7. Infrastructure makes the economy more attractive to future flows of inward FDI

8. We need better infrastructure to cope with forecast population growth - the Office for National Statistics forecasts that the UK population will grow to over 73 million

people by 2035.

What are the counter-arguments to the “balanced budget fiscal expansion” view?

Fiscal conservatives argue that strong action is needed to lower the deficit both in absolute terms and also as a share of GDP. They argue that the economy will benefit in the medium term if government finances are brought under control:

1. Lower borrowing means that the UK economy will retain a high credit rating and this will mean lower interest rates on government debt and newly-issued corporate bonds.

2. Less interest paid on debt frees up more money to be reinvested in key public services such as health or education.

3. Reducing the debt opens up the possibility of consumer and business tax cuts – a strategy that free market economists support as a way of stimulating fresh growth in the private sector.

4. Tighter control of government spending / a lower fiscal deficit makes it more likely that the

Bank of England will be able to keep policy interest rates lower, again helping the economy to recover more strongly.

5. Some economists have claimed that economic growth tends to be lower on average among countries with government debt/GDP ratios above 90%.