Long-Run Effect of Budget Cutting in the UK - Essay Example

Macroeconomics long-run effect on budget cutting in the UK Introduction It has been observed that when the new Conservative-Liberal Democrat government came into power in 2010, the first thing it did was to cut the state spending to an extent, that has been estimated to be the highest post second world war. This project aims to understand the impact of the budget cut on the macroeconomic variables like real wages, investment, national saving, real interest rate, nominal exchange rate, real exchange rate and trade balance in the long run. The term nominal interest rate represents the rate of interest before taking inflation into account and the term real interest rate explains the real cost of funds to the borrower after taking into consideration the rate of inflation. Spending cuts and its effects One of the primary concerns of the governments in UK, both the previous Labour Government and the present government, has been to reduce the public borrowing to sponsor the expenditure of the government (Giudice, Kuenzel and Springbett, 2012). The agenda behind the reduction in the public spending is that it is believed that the economy will grow faster in the medium-term. The simple economics behind the fact is that if business corporations believe that the economy will grow in the medium-term then the confidence in them increases which raises their present level of investment. On the other hand the consumers increase their spending with the belief that the economy will grow in the future. However, the standard component of GDP can be represented as (Mankiw, 2011): Y= C + I + G + NX Y= Output, C= Consumption, G= Government purchases and NX= Net exports. This implies that with reducing in spending by the government the total output of the economy falls. However, it is now an established economic convention that the level of output will increase up to a certain point with rise in government spending after which it tends to fall (Lilico, 2012). Closed Economy and Open Economy If the government follows a contractionary fiscal policy, which implies a reduction in spending by the government then the magnitude of impacts of the same is different in case of an open economy and closed economy. A closed economy structure is one that can be described as an economy which involves in no trading activity. A closed economy is assumed to be self-sufficient and all the needs of the consumers are met from inside which eliminates the need of the economy to have any trading relations with the outside world. An open economy on the other hand is the one which has sufficient treading relations with the other countries in the world and there are no barriers to the development of the free market forces. An ideal open economy is the one that is characterized by tariffs, quotas, licensing requirements or any other form of restrictions that hamper the development of the free market forces (Arnold, 2013). The impact of a reduction of government spending on an open economy and a closed economy can be explained with the help of the following graph: Figure 1: Effect of Contractionary Fiscal Policy (Source: Arnold, 2013) The downward sloping lines marked by AD1, AD2 and AD3 represent the aggregate demand curve of the economy. The upward sloping curve marked as SRAS1 and SRAS2 represents the short run aggregate supply curves of the economy. A cut in the government spending is represented by the leftward shift of the aggregate demand curve. To reach the new equilibrium the aggregate supply curve shifts to AD2 in case of a closed economy and to AD3 in case of an open economy. This indicates that the fall in output in the short run is more in case of closed economy than in case of an open economy. A reduction in the government spending reduces the budget deficit and the borrowing of the government from the credit market falls. This fall in the demand for the loanable funds reduces the real interest rates which in turn increase the demand for foreign investments and the currency value of the home country depreciates in value. It appears that the effect on the economy is twofold, on one hand the real GDP falls in the short-run and on the other hand cut in the deficit financing lowers the real interest rates and this lead to capital outflows out of the country and a depreciation in the value of the currency. The depreciation in the value of the currency is the factor which pushes the aggregate supply curve rightwards and raises output. In a closed economy the depreciated value of the dollar will not feed back into the domestic economy and the initial contractionary effect of GDP fall will not be crowded out. However, in case of an open economy the feedback effect of the depreciated currency contributes in offsetting the initial decline. The effect of contractionary fiscal policy in the long run can be explained with the help of the following diagram: Figure 2: Long-Run Impact of contractionary fiscal policy (Source: Swanenberg, 2005) The contractionary fiscal policy followed by the government will cause the aggregate demand curve to shift leftwards, the equilibrium level of output will fall from the level Yp to the level Y3 to restore equilibrium and the price level will fall from P1 to P2. In an open economy, if the government follows a contractionary fiscal policy, then this will lead to a fall in the aggregate demand. However the impact of the policy will be not very effective in slowing down the economy. The effectiveness of the policy will be further less in a closed economy because the economy will not be able to utilize the impact of the depreciation in the currency. In the long run the output of the economy will ultimately increase with a strategic policy mix followed by the government (Swanenberg, 2005). Effect on Macroeconomic Variables UK is a country whose economy can be characterized as an open economy as the country has trading relations with the other countries. The reduction in the government spending in UK is driven by the assumption that the consumers are forward looking yet they are not fully Ricardian in their assumption. The consumers expected to discount the future income streams at a rate that is higher than the rate of interest on the government debt. It is therefore expected that a fall in the government spending will be accompanied by the fall in the real interest rate which will eliminate the possibility of excess supply in the long run. This will raise the level of the investment. The rationale for following the reduction in the government spending is driven by the fact that higher investment will raise the capital stock and the capital output ratio of the economy. The falling interest rates on the other hand will be consistent with the lower marginal product of capital. It is also expected that under these circumstances the level of output will increase in the long-run and this will be attributable to a higher share of capital stock as the units of labour employed remains the same. With this background knowledge the essay focuses on the impact of the cuts of government spending on the macroeconomic variables that has been described earlier. The impact on the real wages depends on a large extent to the overall conditions of the labour market. It has been observed that the level of unemployment in UK in the most severe periods of the recession was not higher than the level of the unemployment in the period of 90’s (IFS, 2013). One of the reasons that explain how the country was able to maintain its level of structural unemployment is the flexibility in the labour markets which allowed the real wages to fall. This implies if the government wants to reduce the budget deficit one of the most efficient ways of doing this is reducing the public wages of the labourers or reducing the level of employment in the public sector. In order to achieve this objective the government has been constantly reducing the real wages in an attempt to reduce the budget deficit. The recession has been prompting huge decline in the real wages of the labourers. The fall in the wage has been recorded constantly over the period of the five years. However, the economy is on a steady path of recovery in the recent times and with the improvement in the pace of the recovery it is expected that wages can rise in the future. The impacts on every macroeconomic variable have a close relation to the way the policies are designed in the world economy. The closer integration of the world economies have lead to a situation where the impact of any economy cannot be treated in isolation not taking into consideration the impacts of policies on the other economies. Again on the other hand there is close integration between the economic variables and the way they are affected by policies of the government. When the government lowers the level of spending, the domestic real interest rate falls and this fall will impact the level of investment in the long run for the economy. The estimates of the government show that the level of investment will increase in the future. Over the last few years the investment by the business houses have fallen and the capital investment as a share of GDP is at a all time low since the post war. These results are not surprising as the any consolidation policy followed by the government in short-run is bound to introduce distortions in the economy. The ultimate concern of the government is the long-run impact and analysis by government shows that the impact on investment is promising (HM Treasury, 2013). The Spending cuts by the government coupled with other measures of consolidation will create lasting growth and prosperity of the government. As the budget deficit of the government falls in the future due to the austerity measures the government can accumulate surplus which it can later invest in the key areas like infrastructure and this raises the prospect of development in future. The government is trying to channelize the surplus obtained from fiscal consolidation into raising the capital investment of the country which will make the growth of the economy sustainable. The impact on the real interest rate has already been discussed and it has been seen that contractionary fiscal policy in the short-run causes the interest rate to fall. As far as the long-run is concerned it has been observed that the interest rate that interest rate falls in the long run as well to eliminate the chances of excess supply. The impact of the fiscal policy on the on the exchange rate (both nominal and real) will not be conclusive unless the monetary policy of the government is considered. As it is not possible to predict the monetary policy of the government at this point so a qualitative analysis of this segment is a reasonable one. As has already been pointed out that there is a high extent of connectivity between the variables, this fact also holds true for the interest rate and the exchange rate. The purchasing power parity theory of exchange rates can provide a useful insight about the relation between the two variables. It has been observed that the interest rates are dependent on the size of the spending multipliers, income and the supply and demand of money. In case of cut in government spending the rate of change of the exchange rate will depend on the interest elasticities of capital flows. The direction of the outward capital flows will be dependent on the fall of interest rates and the degree of depreciation of the currency (Masson, et al., 2013). The impact of national saving of the country has been estimated that it has been found that the level of national saving, both the private and the public saving are going to be at par with the previous level. This means that the austerity measure of the government will not severely impede the saving prospects of the economy in the long-run (Office for Budget Responsibility, 2011). The fall in the interest rates may reduce private saving in the short-run but over the time the government saving will improve as the government will be able to save more through lesser expenditure and the national savings as a whole will not be severely affected and will continue to be at a comparable level with the past. The impact on the trade balance of the country will largely depend on the spillover effects of the fiscal consolidation. It has been observed that though the level of domestic fiscal consolidation on the trade of the country is sizeable but the level of a spillover can have adverse effects on the economy of the country. If the level of international demand from the other countries remains strong then the recovery of the country will be strong. It is expected that the trade will boost as the economy starts recovery (OECD, 2012). Conclusion On completion of this study a clear picture emerges about the economic structure of United Kingdom in the period of recession. The high level of government budget deficit has contributed to accumulation of huge debts which has contributed to the accumulation of huge debts. To rectify the situation the government has reduced the public spending. In this view the impact of such a change on an open economy and closed economy has been compared. It has been observed that in short-run contractionary policy of the government is bound to reduce output however the austerity seems beneficial in the long run. The impact on the macroeconomic variables is in line with the predictions of the classical model and shows the current levels of investment and savings are low but it will improve in the future. The high dependence of the interest rates on the exchange rates makes it difficult to comment on the changes of these variables. Reference List Arnold, R. A., 2013. Macroeconomics. Connecticut: Cengage Learning. Giudice, G., Kuenzel, R. and Springbett, T., 2012. UK economy: The crisis in perspective. London: Routledge. HM Treasury, 2013. Investing in Britain’s future. [pdf] Crown. Available at: [Accessed 17 January 2014]. IFS, 2013. Workers kept their jobs but one third faced nominal wage freezes or cuts. [online] Available at: [Accessed 17 January 2014]. Lilico, A., 2012. Why does cutting government spending mean faster growth? The Telegraph, [online] 29 April. Available at: [Accessed 17 January 2014]. Mankiw, N., 2011. Principles of economics. Connecticut: Cengage Learning. Masson, P., Wignall, A. B., Barenco, B. and Holtham, G., 2013. Macroeconomic Policies And Exchange Rates. [pdf] Economics and Statistics Department. Available at: [Accessed 17 January 2014]. OECD, 2012. OECD Economic Outlook. France: OECD Publishing. Office for Budget Responsibility, 2011. Economic and fiscal outlook March 2011. London: The Stationery Office. Swanenberg, A., 2005. Macroeconomics demystified. Noida: Tata McGraw-Hill. Read More