Chapter 16

CHAPTER
16
Fiscal Policy and Monetary Policy
After studying this chapter you will be able to: Describe the UK governments recent budgets Explain the effects of fiscal policy on output and employment Describe the objectives and framework of UK monetary policy
Explain how the Bank of England influences interest rates

Explain the transmission channels through which the Bank of England influences inflation and real GDP
Pearson Education 2012
Every spring, the Chancellor of the Exchequer presents his budget. In 2010, UK governments (central and local) spent 47 pence of every pound earned and had a budget deficit of 149 billion. Does a pound spent by the government have the same effects as a pound spent by someone else?
Every month, six eminent economists join the Governor and Deputy Governors of the Bank of England to decide whether to change the interest rate.
How do the Bank of Englands interest rate decisions influence jobs, growth and inflation?
Government Budgets
A governments budget is an annual statement of projected outlays and receipts during the next year together with the laws and regulations that support those outlays and revenues. Fiscal policy is the use of the governments budget to achieve macroeconomic objectives, such as full employment, sustained economic growth and price level stability.
Government Budgets
Highlights of the UK Budget in 2010 The UK budget of 2010 projected receipts of 531 billion, outlays of 695 billion and a deficit of 164 billion. Receipts
Receipts come from four sources:

1 2 3 4 Taxes on income and wealth: 189 billion Taxes on expenditure: 186 billion National Insurance contributions: 97 billion Other receipts and royalties: 59 billion
Government Budgets
Outlays Outlays are classified in three broad categories: 1 Expenditures on goods and services: 388 billion 2 Transfer payments: 265 billion 3 Debt interest: 42 billion
Government Budgets
Budget Balance The governments budget balance equals receipts minus outlays. If receipts exceed outlays, the government has a budget surplus.
If outlays exceed receipts, the government has a budget deficit.

If receipts equal outlays, the government has a balanced budget.
Government Budgets
The Budget in Historical Perspective Figure 16.1 on the next slide shows the governments outlays, receipts and budget balance as a percentage of GDP since fiscal year 1970/71.
The government budget has mainly been in deficit during this period.
Government Budgets
Receipts
Figure 16.2 shows government receipts a percentage of GDP from 1988 to 2010.
Government Budgets
Outlays Figure 16.3 shows outlays as a percentage of GDP from 1988 to 2010.
Government Budgets
Deficit, Debt and Capital
Government debt is the total amount borrowed by the government.

It is the sum of past deficits minus the sum of past surpluses plus payments to buy assets minus receipts from the sale of assets. A budget deficit or the purchase of assets increases government debt. A budget surplus or the sale of assets decreases government debt.
Government Budgets
Figure 16.4 shows that in 1975, government debt was 59 per cent of GDP. During the 1970s and 1980s, the government sold assets such as British Rail and its debt fell. Government debt rose after the 1990-1992 recession. In 2008-2010 with the partnationalisation of two banks and a large budget deficit debt increased.
The Effects of Fiscal Policy

Taxes, government expenditures and the government budget balance influence economic performance in a number of ways. Were going to focus on three of them: The effects of taxes on the incentives to work, invest and save The effects of taxes and government expenditure on aggregate demand Intergenerational effects

Incentive Effects of Taxes A tax on a transaction drives a wedge between the price the buyer pays and the price that the seller receives. The Effects of the Income Tax on Employment Figure 16.5 illustrates the full employment situation in which 50 billion hours of labour are employed.

The income tax decreases the supply of labour because it decreases the after-tax wage rate. The before-tax wage rate rises, the after-tax wage rate falls and employment decreases.
The blue arrow shows the tax wedge.


Taxes on Expenditure and the Tax Wedge
Taxes on consumption expenditure add to the tax wedge. The reason is that a tax on consumption raises the prices paid for consumption goods and services and is equivalent to a cut in the real wage rate. If the income tax rate is 25 per cent and the tax rate on consumption expenditure is 20 per cent, a pound earned buys only 55 pence worth of goods and services. The tax wedge is 45 per cent.

Taxes and the Incentive to Save and Invest
A tax on capital income lowers the quantity of saving and investment and slows the growth rate of real GDP.
The interest rate that influence saving and investment is the real after-tax interest rate.
The real after-tax interest rate subtracts the income tax paid on interest income from the real interest. Taxes depend on the nominal interest rate. So the true tax on interest income depends on the inflation rate.

Figure 16.6 illustrates the effects of a tax on capital income. A tax decreases the supply of loanable funds.
The interest rate rises, but the after-tax interest rate falls.
Investment and saving decrease. The blue arrow shows the tax wedge.

Fiscal Policy and Aggregate Demand The 20082009 recession brought Keynesian macroeconomic ideas back into fashion and put a spotlight on fiscal stimulus the use of fiscal policy to increase employment and real GDP. A fiscal policy action that is triggered by the state of the economy with no action by government is called automatic fiscal policy. A fiscal policy action initiated by government is called discretionary fiscal policy. It requires a change in a spending or tax law.

Automatic Fiscal Policy Tax receipts and means-tested spending change automatically in response to the state of the economy. The government budget balance that arises from the business cycle is called the cyclical surplus or deficit. The budget balance that would occur if the economy were at full employment is called the structural surplus or deficit.

Discretionary Fiscal Policy Changes in government expenditure and taxes change aggregate demand and have multiplier effects. Two main fiscal multipliers are:
Government expenditure multiplier Tax multiplier

The government expenditure multiplier is the quantitative effect of a change in government expenditure on real GDP. Because government expenditure is a component of aggregate expenditure, an increase in government expenditure increases real GDP. When real GDP increases, incomes rise and consumption expenditure increases. Aggregate demand increases. If this were the only consequence of the increase in government expenditure, the multiplier would be >1.
Fiscal Stimulus
But an increase in government expenditure increases government borrowing and raises the real interest rate. With the higher cost of borrowing, investment decreases, which partly offsets the increase in government expenditure. If this were the only consequence of the increase in government expenditure, the multiplier would be < 1. Which effect is stronger? The consensus is that the crowding-out effect dominates and the multiplier is <1.
Fiscal Stimulus
The tax multiplier is the quantity effect a change in taxes on aggregate demand. The demand-side effects of a tax cut are likely to be smaller than an equivalent increase in government expenditure.
Fiscal Stimulus
Figure 16.7 shows how fiscal policy is supposed to work to close a recessionary gap. An increase in government expenditure or a tax cut increases aggregate expenditure.
The multiplier process increases aggregate demand.

Fiscal Stimulus and Aggregate Supply Taxes drive a wedge between the cost of labour and the take-home pay and between the cost of borrowing and the return on lending. Taxes decrease employment, saving and investment and decrease real GDP and its growth rate. A tax cut decreases these negative effects and increases real GDP and its growth rate.
The supply-side effects of a tax cut probably dominate the demand-side effects and make the multiplier larger than the government expenditure multiplier.

Time Lags
The use of discretionary fiscal policy is seriously hampered by three time lags:
Recognition lag the time it takes to figure out that

fiscal policy action is needed.
Law-making lag the time it takes Congress to pass the

laws needed to change taxes or spending.
Impact lag the time it takes from passing a tax or

spending change to its effect on real GDP being felt.
Generational Effects of Fiscal Policy

Is the budget deficit a burden of future generations? Is the budget deficit the only burden of future generations? What about the deficit in the state pension fund? Does it matter who owns the bonds that the government sells to finance its deficit? To answer questions like these, we use a tool called generation accounting. Generational accounting is an accounting system that measures the lifetime tax burden and benefits of each generation.

Generational Accounting and Present Value Taxes are paid by people with jobs. State pensions are paid to people after they retire. Healthcare benefits are also provided on a larger scale to older people. So to compare the value of an amount of money at one date (working years) with that at a later date (retirement/older years), we use the concept of present value. A present value is an amount of money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account.

For example: If the interest rate is 5 per cent a year, 1,000 invested in 2012 will grow, with interest, to 11,467 after 50 years. The present value (today) of 11,467 in 2062 is 1,000.

The UK Welfare State and Pension Time Bomb Using generational accounting and present values, economists have found that the UK is facing a welfare state and pension time bomb! In 2010, more than 12 million baby boomers are retired or of retirement age. By 2033, more than 20 per cent of the population will have reached retirement age. On the arrangements of 2010, outlays on state pensions and the NHS will vastly exceed the 2010 outlays. The obligation to make these outlays is a debt owed by the government.

Fiscal Imbalance To assess the governments obligations, economists use the concept of fiscal imbalance. Fiscal imbalance is the present value of the governments commitments to pay benefits minus the present value of its tax revenues the governments true debt. Four economists at Freiburg University estimate the UKs fiscal imbalance at 510 per cent of GDP. When added to the governments market debt in 2010, the total debt obligation is 575 per cent of GDP or 8.3 trillion (in 2010 prices).

Estimates of UK and Other Fiscal Imbalances Figure 16.8 shows Freiburg economists estimates of eight fiscal imbalances. The UK has the largest fiscal imbalance but the US, Norway, France and Germany also have large fiscal imbalances. How can the UK government meet its pension and NHS obligations?

Coping With Fiscal Imbalances There are five possible ways of coping with the fiscal imbalances: 1 Raise income taxes 2 Raise National Insurance contributions 3 Cut government discretionary spending 4 Cut unemployment and other welfare state benefits 5 Raise the state pension age None of these measures is painless or free from political controversy. By combining the five measures, the pain from each could be lessened, but it would still be severe.
Monetary Policy Objectives and Framework

A nations monetary policy objectives and the framework for setting and achieving that objective stems from the relationship between the central bank and the government. Monetary policy-making involves two activities: 1 Setting the policy objectives 2 Achieving the policy objectives
In most countries, including the UK, the government sets the monetary policy objectives and the central bank decides how to achieve them.

Monetary Policy Objectives The Bank of England Act of 1998 sets out the objectives of UK monetary policy: (a) To maintain price stability,
(b) subject to that, to support the economic policy of Her Majestys Government, including its objectives for growth and employment.
The Act also requires the Chancellor to specify in writing:
(a) What price stability is taken to consist of.

(b) What the governments economic policy is taken to be.

Monetary Policy Committee
The Bank of Englands monetary policy committee is the committee in the Bank that has the responsibility for formulating monetary policy. The nine person committee consists of the Governor, two Deputy Governors, two members appointed by the Governor after consultation with the Chancellor and four members appointed by the Chancellor

Remit for the Monetary Policy Committee
The remit is stated in two parts corresponding to the two monetary policy objectives.
Price Stability Objective
The operational definition of price stability since the beginning of 2004 has been:
An inflation target of 2 per cent a year as measured by the 12-month increase in the CPI. Although the target is renewed annually, the intention is to keep inflation low and stable over the long term.

Government Economic Policy Objectives
The governments economic policy objectives as they relate to monetary policy are to achieve high and stable levels of economic growth and employment.
Price stability is the key goal and a major contributor to achieving the other goals of government economic policy.

Actual Inflation and the Inflation Target Figure 16.9 shows the inflation target range of 1 to 3 per cent a year. The MPC achieved its target from 2004 until March 2007.
But from May 2008 to February 2009 and during 2010 it did not.

Rationale for an Inflation Target
Two main benefits from adopting an inflation target are:

1 The Bank of Englands policy actions are more clearly understood by financial traders.
2 The target provides an anchor for expectations about future inflation.

With few surprises and firmly held inflation expectation, people and firms can make better economic decisions, which help make the allocation of resources more efficient.

Controversy About Inflation Targeting Not everyone agrees that inflation targeting brings benefits. Critics argue that by focusing on inflation, real GDP or unemployment might suffer.
Supporters of inflation targeting argue:

1 By keeping inflation low and stable, monetary policy makes the maximum possible contribution towards achieving full employment and sustained economic growth. 2 Look at the record. From May 1997 until the global financial crisis, the UK did not experience recession.
The Conduct of Monetary Policy

How does the Bank of England conduct its monetary policy? This question has two parts:
What is the monetary policy instrument?
How does the Bank make its monetary policy

decisions?

Choosing a Policy Instrument
The monetary policy instrument is a variable that the Bank of England can directly control or closely target.
The Bank of England has two possible instruments:
1 Monetary base
2 Bank Rate The Banks choice is Bank Rate, which is linked to the repo rate the interest rate at which banks borrow and lend bank reserves in the repo market.

Figure 16.10 shows Bank Rate, which is normally changed in steps of a quarter of a percentage. From 2004 to 2007, Bank Rate was on a rising trend. Bank Rate peaked at 5.75 per cent a year in 2007. Since 2007, Bank Rate has been lowered. By April 2009, it was 0.5 per cent a year.

Having decided the appropriate level for Bank Rate, how does the Bank of England get the Bank Rate to move to the target level? The answer: It uses open market operations to adjust the quantity of reserves, which in turn adjusts the repo rate. To see how an open market operation changes the repo rate, we need to examine the market for bank reserves.

Figure 16.11 illustrates the market for bank reserves. The x-axis measures the quantity of reserves that banks hold on deposit at the Bank of England. The y-axis measures the repo rate.
The banks demand curve for reserves is RD.

The demand for reserves slopes downward because ... the repo rate is the opportunity cost of holding reserves. The higher the repo rate, the smaller is the quantity of bank reserves demanded.

The red line shows the target for Bank Rate. The Bank of England uses open market operations to make the quantity of reserves supplied equal to the quantity demanded at the target rate. The supply curve of bank reserves is RS.

Equilibrium in the market for reserves determines the actual repo rate. By using open market operations, the Bank of England adjusts the supply of reserves to keep the actual repo rate equal to the target for Bank Rate.

The Banks Decision-making Strategy The Bank of England (along with most other central banks) follows a process that uses an inflation targeting rule. To implement its inflation targeting rule, the Bank must gather and process a large amount of information about the economy, the way it responds to shocks and the way it responds to policy. The Bank must then process all this data and come to a judgement about the best level at which to set Bank Rate. The Banks economists provide the MPC with a variety of forecasts and scenarios running two years into the future.
Monetary Policy Transmission

Quick Overview
When the Bank of England lowers Bank Rate:

1 Other short-term interest rates and the exchange rate fall.
2 The quantity of money and the supply of loanable funds increase.

3 The long-term interest rate falls.
4 Consumption expenditure, investment and net exports increase.

5 Aggregate demand increases.
6 Real GDP growth and the inflation rate increase.

When the Bank of England raises Bank Rate, the ripple effects go in the opposite direction.
Figure 16.12 provides a schematic summary of these ripple effects, which stretch out over a period of between one and two years.
Extraordinary Monetary Stimulus

During the financial crisis and recession of 20082009 and its aftermath, the Bank of England took two sets of extraordinary policy actions:
Deep interest rate cuts

Quantitative easing

Deep Interest Rate Cuts The Bank of Englands first and natural response was to lower Bank Rate. But it acted slowly at first because it was more concerned about the risk that inflation would exceed the upper bound of its target than it was about the risk of recession. It wasnt until the crisis deepened with massive bank failures in the US and tottering UK banks that interest rates fell steeply. But starting in October 2008, the fall in Bank Rate was steep, down to 0.5 per cent by March 2009.

Quantitative Easing
The Bank of England launched a programme of Monetary Policy Transmission in March 2009. Quantitative easing (QE) occurs when the Bank of England creates an increase in the monetary base by buying government bonds and high grade corporate bonds in the open market. The sellers of these bonds might be commercial banks but they also are pension funds and insurance companies.

The idea is that QE would make the banks flush with excess reserves, which they would lend to firms and households. The quantity of money would increase and asset prices would rise. With easier access to credit and greater wealth from higher asset prices, consumption expenditure and investment would increase.
Aggregate demand and real GDP would grow more quickly.

The Bank set aside 200 billion for QE purchases.
These massive open market purchases in the market for loanable funds were designed to keep the banks well supplied with reserves.
With short-term interest rates as low as they can go, the goal of QE was to increase the monetary base and lower long-term interest rates. The QE did not lower long-term interest rates and it did not bring a large increase in bank lending and the quantity of money.

The figure shows the growth rate of the M4 definition of money and the money multiplier. After QE began in 2009, both the growth rate of M4 and the money multiplier fell dramatically and remained low during 2010.

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CHAPTER

Fiscal Policy and Monetary Policy

Explain how the Bank of England influences interest rates

Pearson Education 2012

Receipts come from four sources:

Pearson Education 2012

Pearson Education 2012

If outlays exceed receipts, the government has a budget deficit.

Pearson Education 2012

Pearson Education 2012

Pearson Education 2012

Pearson Education 2012

Government debt is the total amount borrowed by the government.

The Effects of Fiscal Policy

Pearson Education 2012

The Effects of Fiscal Policy

The Effects of Fiscal Policy

The blue arrow shows the tax wedge.

The Effects of Fiscal Policy

The Effects of Fiscal Policy

The Effects of Fiscal Policy

The Effects of Fiscal Policy

The Effects of Fiscal Policy

Pearson Education 2012

The Effects of Fiscal Policy

Government expenditure multiplier Tax multiplier

Pearson Education 2012

The Effects of Fiscal Policy

Pearson Education 2012

The multiplier process increases aggregate demand.

The Effects of Fiscal Policy

The Effects of Fiscal Policy

Recognition lag the time it takes to figure out that

Law-making lag the time it takes Congress to pass the

Impact lag the time it takes from passing a tax or

Generational Effects of Fiscal Policy

Generational Effects of Fiscal Policy

Generational Effects of Fiscal Policy

Pearson Education 2012

Generational Effects of Fiscal Policy

Generational Effects of Fiscal Policy

Generational Effects of Fiscal Policy

Generational Effects of Fiscal Policy

Monetary Policy Objectives and Framework

Monetary Policy Objectives and Framework

(a) What price stability is taken to consist of.

Monetary Policy Objectives and Framework

Pearson Education 2012

Monetary Policy Objectives and Framework

Monetary Policy Objectives and Framework

Pearson Education 2012

Monetary Policy Objectives and Framework

Monetary Policy Objectives and Framework

Two main benefits from adopting an inflation target are:

2 The target provides an anchor for expectations about future inflation.

Pearson Education 2012

Monetary Policy Objectives and Framework

Supporters of inflation targeting argue:

The Conduct of Monetary Policy

What is the monetary policy instrument?

How does the Bank make its monetary policy

Pearson Education 2012

The Conduct of Monetary Policy

Pearson Education 2012