Readers Question: hi, would you please state which base rate the monetry policy should be in December. Taking into account all the economic factors in the UK.
interest-rates-nov
As you can see the Bank cut interest rates by a record 150 basis points in November. Yet, I think interest rates should be cut by another 0.5% in December to 3.0%
The Outlook for the economy is gloomy
Unemployment is rising sharply, and with the negative economic growth it could be reaching close to 3 million by the start of 2010 / end of 2009.
Inflation is 5.2%, but this is really reflective of the cost push factors we experienced earlier in the year. Now that these cost push factors have been reversed, inflation will surely drop sharply. Indeed there is concern that the UK could experience deflation. Deflation would be very damaging which is why the MPC will be willing to loosen monetary policy again.
The Pound is falling (25% against the dollar) Usually, this would be a cause for concern because a falling pound could be inflationary. But, in the current climate, the MPC are unlikely to be too worried about a falling pound. If anything it will offer some relief to beleagured manufacturers. (Why we shouldn’t worry about falling pound)
Housing Market continues to deteriorate. House prices have now fallen 14% and there appears no end to the decline. With rising unemployment, interest rates cuts will prevent home repossessions rising.
As well as interest rate cuts, the government is planning tax cuts which will help to boost AD.
Why is monetary policy easier to conduct than fiscal policy in a highly divided national political environment?
Monetary policy is usually implemented by independent monetary authorities. For example, in UK, monetary policy is implemented by MPC. Therefore, they can take politically unpopular decisions such as increasing interest rates to reduce inflationary pressure. When governments set interest rates, it was a highly charged political decision. e.g. industry lobbying for rate cuts to avoid unemployment.
Fiscal Policy involves changing levels of taxation and spending. For example, deflationary fiscal policy may involve cutting spending. But, it is difficult to find a department willing to have its spending cut to help the macroeconomy.
Increasing taxes will be unpopular no matter which tax you choose
Expansionary fiscal policy is also not without difficulties. Cutting taxes to boost aggregate demand will be politically popular. But, then the government finds it difficult to reverse the tax cut when the economy starts to grow against.
However, monetary policy is not without its difficulties. e.g. changing interest rates impacts on the exchange rate and therefore exporters. Higher rates hurt borrowers, but, benefit savers.
Readers Question: How could equal-size increases in G and T eliminate a recessionary gap?
In theory, an increase in government spending of £2bn would be an injection into the economy and cause an increase in GDP of £2bn. However, if the government increased taxes by £2bn, the effect would be neutralised. In short higher government spending increases aggregate demand, but, higher taxes reduce it.
Yet, it is possible for equal size increases in G and T to eliminate a recessionary gap.
The government spending should be targeted to building infrastructure projects which employ unemployed people. This spending will have a direct effect in increasing incomes. Many related industries will benefit creating a multiplier effect in the economy. If the unemployed are given jobs to build roads, they get increased income but also will spend more benefiting local shops and bars. Therefore, the initial government injection of £2bn may lead to a final increase in GDP of say £3bn.
If the government increased taxes on wealth or high income earners there may be little negative impact on consumer spending and economic growth. For example, if the government increased inheritance tax by £2bn, there would be little negative impact on consumer spending. People don’t usually spend all their inheritance straight away, but save it in banks.
It is possible the government could increase aggregate demand by increasing taxes on high income earners and cutting taxes for low income earners. This is because low income earners have a much higher marginal propensity to consume. If you place tax on high income earners they will reduce their spending, but, the effect will be less than if you had increased taxes on low income earners.
Readers Question: What is the relationship/theory between the OCR (Official Cash Rate) and Inflation?
The Official Cash Rate is the interest rate the New Zealand Reserve Bank use to control inflation. It is very similar to the base rate used by the MPC, Bank of England.
Graph Interest Rates New Zealand
Interest Rates in New Zealand. Source
Because New Zealand commercial banks borrow from the reserve bank, this official cash rate influences all interest rates in the economy.
The Reserve bank will increase interest rates (tightening of monetary policy) to reduce inflationary pressure.
Higher interest rates:
increase cost of borrowing
increase incentive to save
reduce disposable income of people with variable mortgages
This reduces consumer spending, investment and therefore aggregate demand growth; this helps reduce inflation.
At the moment, the New Zealand Reserve bank is cutting interest rates (like Central banks around the world) because of the global slowdown. WIth inflation falling, the Reserve bank are cutting rates to try and prevent recession.
Generally lower inflation enables lower interest rates. Higher inflation leads to higher rates.
However, sometimes, Reserve banks will increase interest rates in anticipation of inflation.
Or at the moment, the Bank of England is cutting rates aggressively in anticipation of lower inflation next year.
Graph inflation NZ
Inflation in New Zealand. Source
Forecasts for NZ Inflation and Interest rates
With end in cost push inflation and the global slowdown spreading, the NZ economy is likely to have lower inflation and lower interest rates in 2009
Readers Question: What is meant by the term inflationary noise ?
Definition of Inflationary noise. When inflation distorts price signals.
If inflation is 0%, and Peugeot cars increase in price then this is a signal Peugeot are more expensive. However, if inflation is 5 or 6%, it is harder to work out whether the increased price of Peugeot cars is due to inflation or an increase in the relative price.
Inflationary noise is more of a problem when inflation is unexpected. e.g. if inflation is always 2% and this is what people expect, it is easier to work out relative prices. However, if inflation is unexpectedly high, it becomes more difficult to work out relative price changes.
Deflation would also make it difficult to work out relative prices.
Readers Question: Could deflation lead to devaluation of the UK Pound?
Deflation in the UK means prices fall. This hasn’t happened since the 1930s, but, if it did happen, it could lead to a further depreciation in Pound Sterling.
Firstly, deflation would mean interest rates would likely fall to 0%. This fall in interest rates would make it less attractive to save in the UK, reducing hot money flows. UK investors would save oversees. The recent fall in the Pound sterling, is due in part to the deterioration of the economy and expectation of lower interest rates. Deflation would imply a serious downturn and interest rates would fall close to 0%. This would have a big impact on reducing demand for sterling.
However, if the UK has falling prices and other countries have inflation, then in theory UK goods will become more competitive and this might increase demand for sterling. If the deflation is caused by increase in competitiveness and better productivity this should increase demand for UK Exports and therefore help sterling rise.
I believe the interest rate factor would outweigh the increased competitiveness though and Pound Sterling would fall.
Benefits of Depreciating Pound
British Exports will become more competitive. However, in the current climate, the fall in the value of the pound has not really helped exports. This suggests that demand is relatively inelastic and also it reflects the slowdown in global growth. In other words despite lower prices of UK exports the demand isn’t really there. However, in theory the depreciating pound should help boost exports and growth
Cost of Depreciating Pound
In theory, the depreciating Pound could cause inflation (rising AD, more expensive imports). However, since the UK is in a recession, inflationary pressures are muted. Readers Questions If so, could there then be a case for the UK joining the Euro (if devaluation meant parity with Euro)?
Generally, university education does offer some external benefits to society. Therefore, there is a justification for the government subsidising higher education. There is also a powerful argument that university education should be free to ensure equality of opportunity. However, just because higher education is beneficial to society doesn’t mean we are obliged to offer unlimited funding. Perhaps society would benefit if the government offered more free training so people could become plumbers, electricians. If we spend billions on free university education there is an opportunity cost of higher taxes or less spending elsewhere. Because so many people go to university, it is unfortunately necessary we need to charge at least some students for higher education. However, I really question whether we need 50% of students to go to university. This is main reason why cost of university education is rising and government are having to use more top up fees.
Today, Mervyn King painted a gloomy picture of the UK economy. He said:
“It’s very difficult to know how long we’ll be in recession. I think we probably are in recession now - 2009 is going to be a difficult year.”
Mervyn King also said inflation was likely to fall below the target of 2% next year, but he admitted the outlook was generally bleak and would not hesitate to cut rates again if necessary. Quotes by Mervyn King from November inflation Report.
The report came out on a day when unemployment rose to an 11 year high of 1.825million. [link] Unemployment is forecast to rise sharply as the economy continues to contract and unemployment often lags 6 months behind changes in economic growth.
The causes of the sharp economic downturn in 2008 are:
Readers Question: discuss the implications of the different definitions of horizontal equity?
I’m afraid I am not familiar with the different definitions of horizontal equity.
Horizontal equity implies that we give the same treatment to people in an identical situation. E.g. if 2 people earn £15,000 they should both pay the same amount of income tax. Therefore, horizontal equity makes sure we don’t have discrimination on the grounds such as race / gender / different types of work.
Vertical Equity: Implies that that people with higher incomes should pay more tax. Vertical equity seeks to tax in a proportional or progressive way - People with more ability to pay should pay more tax.
Horizontal equity is an important starting point for any tax system. Horizontal equity can be consistent with also achieving vertical equity. Horizontal equity is the equal treatment of equals and this is a means for achieving a distribution of tax burdens that is vertically equitable.
Examples, The Poll Tax is an example of a tax that has horizontal equity (everyone pays a lump sum of £500 a year). Mrs Thatcher’s theory was that since everyone had the same access to council services everyone should pay the same tax. However, the poll tax does not meet the criteria for vertical equity. For those on low incomes, the poll tax was a high % of their disposable income. For those on high incomes and more ability to pay it was a low %.
Different Types of Horizontal Equity
I’m afraid I can’t help you out here. You might look at:
