THE UK ECONOMY FINAL Essay

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THE UK ECONOMY
Economics Coursework
Nikhil Rawal 130014317 & Vivek Patel 130001482
2014

Introduction

In this report we will be analyzing UK’s current macroeconomic position relative to the Global Financial Crisis (GFC) of 2008/09 and the measures implemented by the fiscal and monetary authorities to revive the economy. Currently the economy can be characterized by the following quote: ‘The recovery has gained momentum, output is growing at its fastest rate since 2007, jobs are being created at the quickest pace since records began and after 4 years of above target the inflation rate is back at 2%’, Mark Carney, Governor of the MPC.

We must first consider the following graphs on the macroeconomic performance in the UK.

During times of recession, economic activity as represented by Aggregate Demand (AD), declines and hence stimulus needs to be introduced in the economy. AD comprises of the following components: Consumption (C), Investment (I), Government spending (G), and Net exports (X-M). There are two demand-side policies that the UK can employ in order to influence AD, these are: fiscal and monetary. In addition to this we will look at quantitative easing as another measure to boost the economy.

Fiscal Policy

This works through the government’s budget and involves the use of taxation and government expenditure to influence AD. The UK government employed the deflationary fiscal policy at the time. This entailed increase in indirect taxes (VAT) and a reduction in government spending.

VAT increased from 15% in 2008 to 20% in 20131. These are the possible implications of this effect on inflation and unemployment. The increase in VAT leads to a fall in disposable income for consumers, ultimately causing a fall in consumption. Consumption is a major component of AD and therefore AD falls.

The fall in consumption signals fall in demand for businesses and these firms respond by cutting output. As a result, the firm engages in rationalization measures i.e. cutting costs by laying off excess employees contributing to higher unemployment in the private sector. Reduction in government spending over the period from 2009 has resulted in no further creation in public sector jobs.

Quantitative Easing

The Bank of England and the Federal Reserve have used Quantitative Easing (QE) as a measure to revive consumer spending and economic growth following the GFC. QE involves Central Banks raising the amount of lending and activity in an economy by increasing its stock in assets. This usually happens by purchasing government bonds from either commercial banks or other financial businesses, such as insurance companies and pension funds, in order to ultimately increase money supply. The diagram below illustrates this:

During the GFC, the MPC had approved to purchase £200 billion worth of assets, mainly from government debt or ‘gilts’. In October 2011 the MPC again authorized further purchases of £75 billion and thereafter £50 billion in February 2012. With another £50 billion added the MPC’s total, QE has accumulated to £375 billion as of July 2012. Since then it has been unchanged2.

We must first understand how QE influences the level of AD in an economy. It has four main transmissions; firstly through the interest rate. The monetary policy adjustments only affects short-term interest rates i.e. those on borrowing and lending. When the UK implemented the QE policy by purchasing large quantity of government bonds (£375bn) it affects their yield and prices, therefore influencing the long-term interest rates. This is especially the case since short-term interest rates where significantly low already. Secondly through money supply. By acquiring more asset stock it directly causes a rise in the money supply in the economy. Households and investment institutions will be motivated to start spending and since the commercial banks would be more willing and able to lend more, the
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