The economy functions by encompassing two systems, the monetary side comprising money, prices and related systems and the more physical side which relates to resources and products. Just as computer software contains an operating system and applications. The economy’s operating system is said to be its monetary system (El-Erian & Ip, 2010). The institutions are its applications that operate using the monetary system. These institutions can be grouped as the private sector which also consists of businesses and private sectors, the government sector which is all the levels of government that tax and provide services and finally the quasi-government sector that comprises government owned enterprises that, like the private sector, earn their income by charging for services.
An economy’s monetary system can be controlled through interest rates and money supply. The rules that govern how money is created and distributed alters the behaviour of the economy. In china, money is created mainly from the growth of export income this will behave completely differently to the UK were the main source of additional money is bank credit. The effectiveness of money comes from the flow of money between those who need the money immediately to buy products or repay debts and those that have the money. The Radcliffe report highlights how these monetary measures work through their effect on total demand. There are two possible effects the direct effect on interest rates on spending (Datta, 2011) particularly on investment spending, and the indirect effects such as rises on interest rates, so long as they are not movements of short rates this can make financial institutions less willing to lend by making them less liquid.
The gross domestic product measures the value of output produced within the domestic boundaries of the UK over a given time period. Economic production and growth, is what GDP represents, it has a large impact on nearly everyone within that economy. Looking at Figure 1 the GDP growth in UK has declined rapidly plummeting below – 4% after the recession that hit in 2008, this slowly picked up as monetary measures were made by central banks in a bid to pull Britain out of the financial crisis. However, the GDP growth in rapidly developing countries such as China has continued to rise despite the rest of Europe’s declining bank system.
Figure 1: Created using Google public data. Available from;
http://www.google.co.uk/publicdata/directory [Accessed: 16/04/12]
Figure 2: Created using Google public data. Available from: http://www.google.co.uk/publicdata/directory [Accessed: 16/04/12]
Comparing the national income annual growth and the GDP growth rate graphs, you can determine that there is a correlation as the GDP growth rate has decreased in the UK so has the net national income there has been a decrease in growth from 2008 onwards. As the growth of the net national income has decreased, leading to low unemployment and wage increases as businesses demand labour to meet the growing economy. Looking at more developed countries such as China you can determine from Figure 1 and 2 that it has had the opposite impact, the rising GDP has led to a higher employment rate, hence increased wages.
The Bank of England controlling interest rates have been the main instrument of monetary policy; UK currently uses the floating exchange rates. However, with the growth of debt due to the recession, the effectiveness of using interest rates in controlling monetary growth has been weakening. The traditional model relies on the demand for credit rising as interest rates fall, thereby raising the money supply.
Figure 3: Adapted from (Lipsey & Chrystal,2011, pp 5-24)
The graph above demonstrates how the impact of the Bank of England raising interest rates, on the capability of existing borrowers to repay their debt has dropped. When the interest rate is too high borrowers are unable to repay the interest. This can lead to any increase in the interest rate leading to the cost of the additional interest being higher than loan repayments. Therefore, higher interest rates would actually increase borrower’s debts leading to an increase in the money supply. Loan repayments represent savings in the economy. The bank sees interest as income and distributes this income back into the economy to distribute dividends and pay costs. New lending is frequently called investment as it represents an injection of new money into the economy and loan repayments represent savings in the economy.
The Bank of England has currently adopted a policy of lowering interest rates in order to stimulate the economy; this however does not provide a long term solution. Eventually, interest rates will fall to zero and debt will grow to such a level that loan repayments will equal the amount of new lending at that interest rate (Moynihan & Titley, 2001). This will lead to the economy becoming fully saturated with debt and therefore no other options to stimulate the economy.
Currently the bank of England has set interest rates at 0.5%. Figure 4 shows the impact of interest rates at zero. At this level of interest, the rising debt shifts the loan repayments schedule to the right. The economy reaches the point shown in the graph below where loan repayments equal new lending, resulting in the economy becoming fully saturated with debt. The British economy then ceases to grow. This is likely to lead to a recession similar to USA, or deflation as experienced in Japan. In both cases, interest rate policy soon becomes an ineffective tool to manage the monetary system.
Figure 4: Adapted from (Lipsey & Chrystal,2011, pp 5-25)
Should the central banks use the money supply as a policy tool? should central banks increase money supply when it wants to stimulate the economy increasing output and reducing unemployment or should it increase the money supply and let the rest of the economy adjust to it?. These are held by two opposing parties the keynesians and the monetarists (Mankiw and Taylor, 2011). The keynesians believe it makes sense to use the money supply as a policy tool, which is monetary policy by influencing interest rate can stimulate investment spending and cause the economy to expand. On the other hand monetarists believe that the only influence money exerts on the economy is an influence on the price level that is if the money supply grows too fast it can spark inflation, the government trying to fine tune the economy will only cause problems such as price instability and confusion therefore reducing efficiency.
The Keynesian position says monetary policy could be beneficial to the economy, and the monetarist position explains that the government should maintain a stable money supply and let the rest of the economy adjust to this. If we hold the velocity of circulation constant and spend money at a constant rate, then any change in the money supply is going to affect the GDP. The way in which it influences the GDP distinguishes the keynesians from the monetarists. The keynesians believe that if you increase the money supply then in the short run you are going to cause interest rate to fall and stimulate investment spending. The increase in demand in the economy, can lead to factories producing more and real output increases. In the short run the price level is going to go up, so the keynesians see an adjustment in the short run, with higher prices and output when the money supply is increased. In the long run this will dissipate as output has to return to full employment but at least in the short run the increase in money supply can cause the economy to expand.
The monetarists have their routes in classical thinking, that wages and prices adjust quickly they are not as sticky like in the keynesian approach. If wages and prices adjust quickly then the economy is always at the speed limit, which is increasing output beyond full employment prices and wages rise until the economy is restrained to full employment. If this is the case were we always have to be at full employment, then an increase in the money supply immediately creates an increase in prices with no change in the real economy. However, if you’re a monetarist you don’t believe increasing the money supply is going to stimulate output or reduce unemployment or achieve any of these goals that concern the real economy. Therefore the best thing you can do for the economy is keep the money supply growing at a constant rate, so you can keep the rate of inflation predictable, increases in the money supply could throw off the economy by unexpected inflation which could then lead to all kinds of problems.
Monetarists assume there is a direct relationship between the growth of the money supply and inflation. The increase in demand for goods and services may cause a rise in imports. This leakage from the domestic economy reduces the money supply; it also increases the supply of pounds on the foreign exchange market consequently applying downward pressure on the exchange rate, resulting in imported inflation. If excess money balances are spent on goods and services, the increase in the demand for labour will cause a rise in money wages and unit labour costs. This may cause cost-push inflation, policies to control inflation need to focus on the underlying causes of inflation in the economy.
Higher interest rates reduce aggregate demand they can discourage borrowing by households and companies as well as increasing the rate of saving. Rising mortgage interest payments can also reduce the homeowners’ disposable income. Business investment may also fall, as the cost of borrowing funds will increase. Fiscal policy can also be introduced to lower government spending and reduce government sector borrowing as well as higher direct taxes (Sloman & Wride, 2009). Exchange rate, interest rate and money supply policies are different throughout the BRIC countries. Russia and Brazil currencies are linked to raw materials. Chinas currency is connected to the Dollar and India floats. The pound makes British exports more expensive and should reduce the volume of exports and aggregate demand. A stronger pound reduces import prices and this makes firms’ raw materials and components cheaper; therefore helping control costs. Increasing the value of the exchange rate might be reached by increasing interest rates or through the purchase of sterling via central bank intervention through foreign exchange markets. Incomes policies set limits on the rate of growth of wages which have the potential to reduce cost inflation.
We can conclude that central banks can influence national income in various ways by controlling monetary policies such as increasing money supply and adjusting interest rate introducing fiscal policies or choosing to adopt a floating or fixed exchange rate thus having a knock on effect on employment and inflation. It is difficult to predict and choose a theory that will be more effective for the sustainable growth of the economy for central banks as both keynesian and the monetarist approach have opposing views and can affect the national income unpredictably until implemented, however this can have detrimental effects on the economy.
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