Why Is the Financial Sector so Important to the UK Economy - Essay Example

Why is the financial sector so important to the UK economy? Why is the financial sector so important to the UK economy? The financial sector is made up of money markets, institution offering banking services and brokers. The sector is of paramount importance since it controls the economy of a country, which in turn regulates the rate of development in the country. United Kingdom is among the countries leading in financial excellence since it has had a competitive financial sector, which has earned it a comparative advantage economically. The financial sector in the United Kingdom mobilizes savings and gives emphasis on credit allocation. An effective financial sector reduces the cost and risk of goods and services production and thus raises living standards as well as the economic state of the country. The superiority of the UK economic sector has been supported by the strength of their currency as compared to that of other countries they trade with. The UK’s pound has enabled the country as well as individuals trade internationally without suffering the consequences of a weak currency. The strength of the UK currency is affected by three factors; interest rates, economic policies and stability. United Kingdom has enjoyed a long period of political stability and hence its currency has not had a period of downfall and thus its progressive increase in strength. The government’s use of a well-established rule of law and the history of constructive economic policies have attracted investment and in turn promoted the strength of the currency (Homer and Sylla, 2005, p.77). The UK economic policy has been shaped by the major global financial changes that affect the world economy. The United Kingdom has enforced economic policies that have facilitated increase in volumes of production and manufacturing. The national government has worked in collaboration with the monetary policy committee for flourish the economic sector by enforcing beneficial economic policies (Cornyn and Mays, 2011, p.24). Cases of financial downturn have been handled using uncompromising corrective measures. The bank of England has played a major role in the UK economy since it has brought down the interest rates down to 1 %. This was done in order to comply with the economic policies laid down by the government. This has significantly brought down the lending expenses and thus more funds available for business, companies and individuals (Zagst, 2002, p.112). Quantitative easing is another economic policy used by the UK that was initiated by the bank of England and it tries to increase the amount of money in the banking system of the United Kingdom (Brigham and Ehrhardt, 2013, p.43). With many funds in the banking system, people are able to get access to funds to start up new projects or complete existing projects. On average, there is a lot of money circulating in the economy at all seasons that encourages investment in the UK and thus their technological and financial dominance. The government has reduced the rate of value added tax from 17.5% to 15%, which has allowed consumers to spend the extra cash on other commodities, which in turn improves the retail sector. The government has also enforced policies that govern insurance of banks and other financial organizations against the after effects of loans. These policies have ensured that the government can be in control of the money in circulation and thus regulate the economy (Zagst, 2002, p.112). Interest rates in the United Kingdom vary depending on the financial institution offering the loan and the financial situation at the moment. However, the policies of the central bank (Bank of England) play a great role in its determination since they determine the cash reserve ratio and the repo rate and reverse repo rate. The bank of England controls the amount of money in circulation the rates of interest to be charged on loans (Zagst, 2002, p.101). Another factor affecting interest rates is periods of recession, which are characterized by slow economic activities, during such periods the interest rates are reduced since the demand of credit is low. Inflation leads to increased interest rates due to the fear of change of purchasing power of the loaned amount (Zagst, 2002, p.80). A favorable economic state leads to increased expectation of profits in the future that prompts people to seek for loans to invest. The high number of people seeking for loans leads to an increase in interest rates (Zagst, 2002, p.81). During unfavorable economic states, very few people want to invest and thus the interest rate on loans goes down. Like any other country, United Kingdom experiences inflation from time to time, which has advantages as well as disadvantages. The current consumer index in UK is 127.7 monthly with an inflation rate of 1.6 %( month of April 2014). Inflation can be classified as either demand-pull inflation or cost-push inflation depending on its cause (Friedman, 2002, p.49). Demand-pull inflation is caused by a faster rate in demand as compared to rate of supply (Friedman, 2002, p.41). The competition of the goods or services leads to increase in their prices and if the increase does to a higher level and persists over a long period, the situation is termed as inflation. On the other hand, cost-push inflation occurs when the cost of production of goods increases and thus their subsequent prices increase (Friedman, 2002, p.30).When the situation stand for long periods of time, the situation is termed as cost-push inflation (Friedman, 2002, p.31). The consequences of inflation are severe and can destroy the economy of a country despite it having a few benefits. Inflation leads to a fall in the value of money such that a unit of money purchases lesser goods than before. This reduces the amount of sales done which consequently reduces the governments’ income and thus a reduction in the economic growth. Inflation leads to an increase in interest a situation that happened in the United Kingdom in the year 1999 and reduced the economic growth rate by 3.7%. Inflation leads to a fiscal drag in that the government adjusts the tax brackets in order to maintain its expenditure and thus people are taxed more. Inflation creates a fear to invest among people and this uncertainty leads to low investment and hence a drag in economic growth. Inflation leads to higher inflation in that people purchase more goods now to avoid spending ore in future. This increase in demand during inflations elevates the level of inflation. Persistent inflation reduces the international competitiveness of a country since there are fewer exports as compared to imports. Despite the negative effects of inflation, it can have positive effects since a continuous and steady inflation can encourage firms to increase output and hence generate profits. Exchange rates can also be termed as foreign-exchange rate or forex rate and is defined as the rate at which one currency will be exchanged with another (Copeland, 2010, p.19). The exchange rates are determined by foreign exchange markets that are open to a variety of buyers and sellers all with different trading currency (Copeland, 2010, p.19). The currency of the United Kingdom has been constant in the foreign exchange market although its strength is lower than the dollar and the euro (Copeland, 2010, p.20). The strength of the UK currency has been advantageous and has enabled it trade with many countries advantageously. However while trading with countries with stronger currencies they enjoy lesser profits. The strong UK currency has lured traders from other countries to trade using their currency and thus increasing its strength as well as returns to the UK. Changes in exchange rates can have adverse effects on the economy although they take long periods to show (Copeland, 2010, p.22; Copeland, 2010, p.25). This is however dependant on the amount of exchange rate and whether the change in the currency are in short or long term. As the economy adjusts to higher exchange rates, the country with the higher currency experiences an increase in exports than imports while the country with a weaker currency experiences more imports as opposed to exposed. This risks the local industries since the stronger companies outside the country can produce goods at cheaper price and outdo the local companies of terms of price (Copeland, 2010, p.22). With such situations occurring, the exchange rates in the exchange market favor those countries with stronger countries. A strong exchange rate enables United Kingdom to control inflation since the domestic producers are able to rise up against international competitors producing similar goods and could even cut their prices to respond to competition (Morley, 2011, p.56). The finance department in United Kingdom has tried to adapt to high exchange rates by cutting export prices to maintain competitiveness and market share. The industrial sector has also tried to adjust to high interest rates by outsourcing components and raw materials from overseas and looking for labor to increase efficiency and improve productivity. United Kingdom is involved in trade internationally and records of all the transactions are kept to produce a balance of payments. It shows all the visible and non-visible transactions for a period of one year and includes all imports, exports and services. The summary of the economic activities enables a country calculate its profits and can help in budget preparation (International Monetary Fund, 2013, p.55). It enables the financial sector to judge the stability of the exchange rate system. The country can also use the balance of payment to identify whether their debtors are in a position to repay their creditors In conclusion, the financial sector is of much important to the United Kingdom since it dictates the economic status of the country. Bibliography Brigham, E. & Ehrhardt, M .2013, Financial management: theory and practice, Mason press, New York. Copeland, L. S. 2010, Exchange rates and international finance, Addison-Wesley, Wokingham, England. Cornyn, A. G., & Mays, E, 2011, Interest rate risk models: Glenlake press, London. Friedman, M., 2002, Inflation: Causes and consequences, Asia Pub. House, New York. Homer, S., & Sylla, R. E. 2005, A history of interest rates, Wiley, Hoboken. International Monetary Fund, 2013, Balance of payments manual. International Monetary Fund, Washington D.C. Morley, S. A. 2011, The economics of inflation. Dryden Press, Hinsdale. Zagst, R. 2002, Interest rate management, Pringer, Berlin. Read More