Fiscal Policy and Aggregate Demand in the UK - Essay Example

Fiscal Policy and Aggregate Demand in the UK There are mainly four objective of the UK government for maintaining the growth and sustain the development of the nation in one hand and preserve and improving the standard of living of the citizens of the country on the other hand. Theses objectives are- First, the amount and rate of inflation should be low, second, there should be a well-built economic growth but should not be inflationary growth so as to increase the long run trend growth rate of the economy, third, the amount of unemployment should be low and it has to reduce continuously and finally, the amount of deficit on the current account balance of payments should not be large and have to avoid. For achieving theses objectives the government of UK has taken two policy tools- the monetary Policy and the fiscal Policy. Simply, the monetary policy of the government is to control the liquidity balance in the economy effecting the movement of the macro economic variables by adjusting interest rates. On the other hand, fiscal policy is an attempt of the government for influencing the economic activity by changing the level and rate of taxation and government expenditure. (Grant and Vidler, 2000, pp 165-167). In UK, Bank of England is responsible for controlling and directing monetary movement in the economy with the monetary policy. The Bank of England has the power to set the rate of interest independently along with requirements. In case of fiscal policy the government itself has taken important steps in strengthening the fiscal policy framework since taking office. The government directs the fiscal policy decisively and confidently for sustaining medium term public finances based on the authoritarian rules and regulations. If possible the fiscal policy supports the monetary policy regarding the movements of the economic and financial parameters of the country. This balancing approach of the fiscal policy together with the monetary policy, endows with the stage of solidity essential for accomplishing the Government's fundamental economic purpose of providing a high and sustainable growth and employment in the economy. In UK functions of the monetary policy changed dramatically in May 1997 when the Chancellor of the Exchequer provided the Bank of England full autonomy regarding the execution of the monetary policy. When monetary policy aims to managing short term economic imbalances, the fiscal policy is responsible for medium term and long term economic issues. (Smith, 1999, pp 42-45; ). With the helplessness of the classical theory in illuminating the great world depression of 1930s, Keynes came up with the solution and hoisted his views for aggregate demand, which actually determined a country’s level of output and employment. (Langdana, 2002, pp 69-71). With the believe in Keynesian thought, governments took control in maintaining the movements of the key economic factors with the strategy tools of monetary and fiscal policies. In UK there is a tendency to consider the conventional Keynesian effects of the fiscal policy. (Beetsma, R, Favero, C, Missale, A, Muscatelli, A, Natale, P and P, Tirelli, 2004, pp 268-269). The government has two options for implementing the monetary policy depending on its objectives. The first one is the expansionary monetary policy and the other is the contractionary monetary policy. Expansionary monetary policy is to fight against the recession for increasing the level of aggregate demand and on the other hand, the contractionary monetary policy is to fight against the inflation for reducing the level of aggregate demand. In the framework of the aggregate demand-supply mechanism, the monetary policy works primarily through its effect in changing the rate of interest. The supply of money is controlled in an economy through three techniques of the central banks, by the open-market operations, by the change of reserve requirements and by the change of discount rate. Demand for money in an economy is determined by the transaction purposes for buying goods and services and the speculative purposes of its citizens. However, there is an opportunity cost of keeping money in hand. This is nothing but the interest rate that could otherwise be earned by investing in interest earning assets. If the rate of interest increases then the opportunity costs will increase and the people would not like to hold money rather they will seek to earn more interest income by keeping their money in the interest earning assets. So, at the equilibrium point the poise between the aggregate demand and supply of money is maintained with the adjustment of interest rate at a price level. The Central Bank of the economy changes the aggregate demand in the economy by changing the money supply. The extent of independency of the central bank from the government results in the extent of monetary policy implemented by the central bank. (Eijffinger and Haan, 2000, pp 44-46). When the supply of money increases the citizens are endowed with excess money which lead them to invest in share, bonds etc. which ultimately end in the fall of interest rate. As the interest rate goes down the quantity of investments in the economy goes up and the quantity demand for goods and services increases. Therefore, monetary policy mechanism means change of interest rates. If interest rate rises, aggregate demand falls and if interest rate falls aggregate demand rises. (Russel and Heathfield ,1999, 101-104). However, this results in inflation as the general price level of the economy increases. Similarly, the central bank can influence the aggregate demand to fall by increasing interest rate through a contractionary monetary policy. So when the expansionary monetary policy attempts to enlarge the economy by guiding more savings into investment, the contractionary monetary policy tries to decrease the inflationary level in the economy by reducing the demand for loans and so the investment demand and the overall aggregate demand. (Sloman and Wride, 2009, pp 438-446). The fiscal policy of a nation implies the choice of the government on its public expenditure and the level of taxation. Fiscal policy is generally used by the government for influencing the levels of savings, investments and the growth of the economy in the long run and affecting the level of aggregate demand in the course of short run. The aggregate demand of an economy is affected through the change in the government expenditure or tax level in two ways, first there will be a multiplier effect on the economy and second there will be a crowding out effect on the economy. (Mankiw and Taylor, 2006, pp 721-724; Wessels, 2000, pp 170-172). In case of multiplier effect it is argued that the government expenditure has a multiplier effect on the economy’s aggregate demand as by spending one pound the government can lift up the level of aggregate demand by more than one pound. The multiplier can be provided by the following formula− Multiplier= 1/ (1- MPC); Where, MPC= Marginal propensity to consume, i.e., the increment in the consumption of a household due to an incremental increase of income. Since a household will not purchase whole of his/her income, so MPC< 1. So, if the government wants to boost the economy by increasing its public expenditure or reducing tax, these policies will augment the disposable income of the households and through the multiplier effect the aggregate demand will increase. (Gillespie A, 2002, 62-68). However, this may happen that the outcome of the fiscal policy for the increase of aggregate demand through the channel of multiplier effect may not be so much effective one due to the crowding out effect. When the government wants to take the expansionary fiscal policy by increasing the spending, it generally borrows funds for the additional spending. This process leads to the increase in interest rate, the price of the borrowed funds. With the increase of interest rate some private investments will go down reducing some amount of the increased aggregate demand resulted by the multiplier effect, i.e., some amount of the increased aggregate demand in the economy due to increase of government spending crowed out by the consequential increase in interest rate. Therefore, the degree of the fiscal policy in changing the level of aggregate demand in the economy is depending upon the relative strength of the multiplier effect and the crowding out (or crowing in) effect. So, the policy maker can decide upon the appropriate projected level of aggregate demand for the economy and take the corrective measures through the fiscal or the monetary policy. (Griffiths, and Wall, 2007, p 306) Let us now discuss the relevance of monetary and fiscal policy with respect to the present economic conditions of UK. Like all the developed nations of the world UK economy has also been affected by the recent global recession. In the last quarter of 2009, gradually the economists came into believe that the recovery in UK economy started. However, some scholars and policymakers still believe that the economic recovery and expansion is weak at present and it would not be a rational thinking to assume that the economy will not descend back into depression in near future. Let us check some statistical figures now. In February 2010, the budget deficit in the public sector touched £6.0 billion in February 2010. It rises almost double from the February 2009 level. The 2010 level of net capital borrowing has increased to £12.4 billion, almost two times more than the 2009 level. The net public sector debt of the UK government has increased to 60.3 per cent of GDP in February 2010 from 50.5 percent of GDP level of February 2009. At the end of February, 2010 the net debt also increased to £857.5 billion from a level of £712.4 billion in February 2009. (Monthly: £6.0bn budget deficit, March 29, 2010). We have shown the growth of net borrowing of the government as a percentage of GDP over a period of 14 years (1994-95 to 2008-09) in the figure 1. Figure 2 has been depicted to show the growth of the gross consolidated debt of the government as a percentage of GDP over the same 14 years period. Figure 1: Growth of net borrowing as a percentage of GDP Source: UK National Statistics  Figure 1 clearly shows that there occurs a sharp decline of the government borrowing up to 2000-2001, but then the borrowing of the government has risen continuously in a significant way. Figure 2: Growth of debt as a percentage of GDP  Source: UK National Statistics Figure 2 has shown that up to 2002-03 the debt of the government has continuously fallen but after that it has taken a u-turn and has risen significantly. There has been seen a lackluster in business confidence among the business community in the UK. Unemployment level in UK is still high and is expected to amplify more. (Brewer, Browne, Leicester and H Miller, February 2010). A sharp decline in the manufacturing, construction and financial services industries are mainly responsible for this huge amount of unemployment. In the latest budget, the government has already declared that it is going to take a tightening plan in its fiscal policy in the coming years as a debt reduction strategy to support its huge deficit. All these statistics and issues are sufficient to tell that the UK economy is still being affected by the effect of recession. Besides, the government has already cleared its intension regarding its stance towards the fiscal policy. A rational thought could easily understand that now the government is not very enthusiastic to take a huge expansionary fiscal policy like what it did in 1992-2002 to provide a series of fiscal stimuli to the economy. (Sawyer, 2005, p- 12; Regional Trends”, January, 2010). In this respect monetary policy is the mean for boosting the economy. However, considering the present economic condition, it is practical to raise our doubt on the effectiveness of the monetary policy alone. At present since the government is not in a mood to increase its expenditure, so we can at least expect that the government will not move up the tax rate in near future. This may help the aggregate demand not to fall further. Beside if the government cuts the cash reserve ratio with a fall in repo rate, then the private investors will be benefited for getting loans from the banks. Then investment demand will rise which will push the aggregate demand to increase. So a suitable harmonization between the monetary and fiscal policy is needed for the UK economy for improving its conditions not only in the short run but also in the long run. References: 1) Griffiths, A & Wall, S (2007), “Applied Economics”, Prentice Hall, Pearson Education Ltd, England, pp- 305-306. Sloman, J and Wride, A (2009), “Economics”, Prentice Hall, Pearson Education Ltd, England, pp- 438-446; 561-638. 2) “Monthly: £6.0bn budget deficit” (March 29, 2010), Public Sector, Office for National Statistics. Available at: http://www.statistics.gov.uk/cci/nugget.asp?id=206 3) Sawyer, M (2005) “The UK Economy”, Oxford university press, NY. 5) “Regional Trends” (January, 2010), Pricewaterhousecoopers. Available at: http://www.pwc.co.uk/scotland/pdf/regional_trends.pdf 6) Brewer, M, Browne, J, Leicester, A and H Miller (February 2010), “Options for fiscal tightening: tax increases and benefit cuts”, The IFS Green Budget. Available at: http://www.ifs.org.uk/budgets/gb2010/10chap7.pdf 7) Eijffinger, C, . S and Haan, D, J, (2000) “ European Monetary and Fiscal Policy” Oxford University Press, NY. 8) Beetsma, R, Favero, C, Missale, A, Muscatelli, A, Natale, P and P, Tirelli (2004), “Monetary policy, fiscal policies, and labour markets, Cambridge University Press, NY. 9) Langdana, K, F (2002), “Macroeconomic Policy”, Springer Science+Business Media, Inc., NY. 10) Russel, M and F, D, Heathfield (1999) “Inflation and UK monetary policy”, Heinemann, USA. 11) Smith, D (1999), “UK Current Economic Policy”, Heinemann, USA. 12) Mankiw, G, N and P, M, Taylor, (2006), “Economics”, Thomson, UK. 13) Gillespie A (2002), “Advanced Economics through diagram”, Oxford University Press, NY. 14) Wessels, J, W (2000), Barron’s Educational Series, Inc., NY. 15) Grant, S and C, Vidler (2000), “Economics in context”, Heinemann, USA. Read More