How independent is the Bank of England in setting interest rates?

The Bank of England Monetary Policy Committee (MPC) is responsible for setting interest rates and trying to achieve a target rate of inflation. Until 1997, the government set interest rates and monetary policy. But, it was felt that the government might make bad decisions because they would be influenced by short-term political pressures. Therefore, they …

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Ricardian Equivalence

ricardian-equivalence

Definition of Ricardian equivalence This is the idea that consumers anticipate the future so if they receive a tax cut financed by government borrowing they anticipate future taxes will rise. Therefore, their lifetime income remains unchanged and so consumer spending remains unchanged. Similarly, higher government spending, financed by borrowing, will imply lower spending in the …

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Quantitative Easing Definition

definition-quantitative easing

Definition Quantitative Easing. This involves the Central Bank increasing the money supply and using these electronically created funds to buy government bonds or other securities.

definition-quantitative easing

Quantitative easing is a form of expansionary monetary policy. It is usually used in a liquidity trap – when base interest rates cannot be cut any further.

Aim of Quantitative Easing

The aim of quantitative easing is to:

  1. Increase economic activity – Q.E. aims to encourage bank lending, investment and therefore help improve the rate of economic growth.
  2. Higher inflation rate. Quantitative easing may also be used to avoid the prospect of deflation
  3. Lower interest rates on assets

How Quantitative Easing Works

  1. The Central Bank creates money electronically. (This is a similar effect to printing money, except they are increasing bank reserves which don’t need to be printed in the form of cash)
  2. The Central Bank uses these extra reserves to buy various securities. These include government bond and corporate bonds.

Buying these securities achieves two things:

  1. Increased liquidity. Banks sell assets (bonds) for cash. Therefore banks see an increase in their liquidity (cash reserves). In theory, the bank will then be more willing to lend to customers. This lending will be important for increasing investment and consumer spending.
  2. Lower interest rates. Buying assets reduce their interest rate. Lower interest rates on these securities may also encourage banks to lend rather than keep securities which are paying low interest. Higher lending should help improve economic growth.
Therefore, the aim of quantitative easing is to:
  • Increase bank lending leading to higher investment. This should stimulate economic growth
  • Increase inflation. Quantitative easing may be pursued when there is underlying core-inflation close to 0%. 0% inflation and deflation can lead to lower spending and economic growth. Therefore, aiming for a higher inflation rate can encourage spending.

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Economics effects of the UK leaving the European Union

Abstract. A look at the economic effects of Britain leaving the European Union. Summary. The UK has been a member of the European Union since 1973. The European Union gives many economic benefits to member countries. These include free trade, inward investment from European companies, free movement of labour, harmonisation of regulations and qualifications and …

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Economic Welfare

economic-welfare

Readers Question. What is economic welfare? can you please elaborate on how it affects an economy? Definition of economic welfare: The level of prosperity and quality of living standards in an economy. Economic welfare can be measured through a variety of factors such as GDP and other indicators which reflect the welfare of the population …

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Quantitative easing: risks vs benefits

definition-quantitative easing

Readers Question: Could you comment on This BBC programme on Q.E.

The programme highlights several criticisms of Quantitative Easing, especially the Q.E. adopted by the Bank of England.

Since 2009, the Bank of England’s balance sheet has quadrupled, and now a third of all government bonds are now held by Bank of England. The programme fears this is storing up future inflation and a possible loss of confidence in the bond market.

Firstly, just to recap:

Quantitative easing involves

  1. Central Bank creating money electronically
  2. Using this electronic money to purchase bonds (mostly government bonds)

The effect of quantitative easing has been

  • To reduce bond yields on government debt.
  • Increase money supply and bank reserves of commercial banks.

Drawbacks of quantitative easing

  • The new inflow of money into commercial banks from quantitative easing has encouraged banks to use this extra money through greater risk-taking. Some argue that Q.E. has increased the risk-taking nature of banks (a problem behind 2008 crisis)
  • Bond traders have benefited from making large profits out of the Bank of England by manipulating the bond market.
  • Because government debt is being financed by quantitative easing, the government has less market discipline to think about reducing fiscal deficits and tackle the underlying problem of UK public sector debt rising to 100% of GDP by 2016.
  • Quantitative easing has been a stealth method of reducing the value of the Pound and Dollar – and therefore making UK exports cheaper. Some commentators call this currency manipulation (or currency wars). They argue this is unfair on emerging markets who are seeing their exports become less competitive.
  • The increase in money supply has led to an unexpected rise in commodity prices, such as oil. This is unusual when the Western economies are in recession; rising oil prices have led to cost-push inflation.
  • By depressing interest rates, quantitative easing has wiped out people’s return on savings (though share price rises have compensated to a certain extent.)
  • Quantitative easing is causing inflation in the UK. (Inflation has frequently been above the government’s target of 2%, and when the velocity of circulation rises, these extra bank balances will be lent – causing a possible inflationary surge.
  • The scale of quantitative easing could make it impossible to sell bonds back to the market and this will damage the UK’s ability to borrow in the future. If the UK’s ability to borrow is constrained, this will lead to higher interest rates and reduce economic growth.
  • Evidence in the US suggests even raising the possibility of tapering could cause damage to the bond market, and higher interest rates. These higher interest rates could reduce economic growth.

Potential benefits of Q.E.

  • Low bank lending. There is no real evidence that there has been a surge in risky bank lending. In fact, the opposite has been the main concern over the past few years. – A more potent criticism of Q.E. is perhaps that it did so little to increase commercial bank lending. Bank lending is still very low compared to pre-crisis trends.
  • We need fiscal expansion, not austerity. It is a very good thing if Quantitative easing has reduced the need for austerity and immediate measures to cut budget deficits. If the UK has pursued Greek or Spanish style austerity, the UK recovery would have been much weaker or non-existent. A recession is not the time to tackle the public sector debt. The important thing is to promote economic growth; this will enable debt to be tackled in the long term when the economy can better absorb spending cuts and tax rises.

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Capital Mobility and Immobility

capital mobility

Definition of capital mobility – easy for physical assets and finance to move across geographical boundaries.

Capital immobility – when capital faces restrictions on the free movement.

What is capital?

Capital principally refers to physical capital – durable goods used in the production process – machines, factories. This physical capital is determined by levels of investment.

When people refer to capital, they also may mean ‘financial capital’ or ‘short-term capital’. This is not physical machines, but money and liquid assets. This kind of capital can be much more mobile. For example, a multinational may move some of its financial capital from Europe to Australia to take advantage of higher interest rates in Australia.

Therefore capital flows can involve:

  • Foreign Direct Investment (FDI) – e.g. Nissan building a factory in England.
  • Portfolio Flows – short-term capital, e.g. taking advantage of different interest rates and moving saving accounts to a different country
  • Bank transfers.

What does capital mobility mean?

  1. If capital is mobile, then it means it is easy and seamless to move capital from one country to another.
  2. Perfect capital mobility would imply no transaction or other costs in moving capital from one country to another.
  3. Capital immobility means it is difficult and expensive to move capital between countries.

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