Managing the Economy – Monetary Policy
Introduction (Singapore do not control interest rates, hence we look at UK)
- Monetary policy influences the decisions that we make about how much we save, borrow and spend
- Decisions made by the central banks that operate monetary policy can have a powerful effect on consumers and businesses
- Changes in interest rates have both demand and supply-side effects.
What is Money?
Money is any asset that is acceptable as a medium of exchange in payment for goods and services. The functions of money are as follows:
- A medium of exchange used in payment for goods and services
- A unit of account used to relative measure prices and draw up accounts
- A standard of deferred payment – for example when using credit to purchase goods and services now but pay for them later
- A store of value – money holds its value unless there is a situation of accelerating inflation. As the general price level rises, so the internal value of a unit of currency decreases.
The media often talks about interest rates going up, or interest rates going doing as if there was one single or unique rate of interest in the economy. That isn’t true – indeed there are thousands of different rates in the financial markets – it can get confusing!
For example we distinguish between savings rates and borrowing rates, interest rates on secured and unsecured loans and short term and long term interest rates on different forms of savings account.
However we find that interest rates tend to move in the same direction. For example if the Bank of Englandcuts the base rate of interest then we expect to see commercial banks cutting the rates on their loans and lower rates are offered on savings accounts with Banks and Building Societies.
The Real Rate of Interest
- The real rate of interest is important to businesses and consumers when making spending and saving decisions
- The real rate of return on savings, for example, is the money rate of interest minus the rate of inflation. So if a saver is receiving a money rate of interest of 6% on his savings, but price inflation is running at 3% per year, the real rate of return on these savings is only + 3%.
- Real interest rates become negative when the nominal rate of interest is less than inflation, for example if inflation is 5% and nominal interest rates are 4%, the real cost of borrowing money is negative at -1%.
The Bank of England and the operation of Monetary Policy
- Founded in 1694, nationalized in 1946, the Bank of England is charged with providing monetary and financial stability for the United Kingdom
- The Bank of England has been independent since 1997
- The Monetary Policy Committee (MPC) has nine members, some of whom are appointed by the government and some by the Bank of England. The Governor of the Bank has the casting vote if there is an equally split decision on interest rates
- Each month the MPC meets to consider the latest news on the UK and global economy
- Their job is to make a judgement on what is the appropriate level of base interest rates for the UK economy consistent with the need to meet an inflation target set by the government
- That inflation target is consumer price inflation of 2%
- The MPC has one eye on maintaining growth (although a set rate of GDP growth is not part of their target). Inflation is allowed to vary by 1% either side of the 2% target – so they have some leeway.
Official UK interest rates in recent years
Factors considered when setting interest rates
At each of their rate-setting meetings, the members of the MPC consider a huge amount of information on the state of the economy. Here are some of the factors they consider when making rate decisions.
GDP growth and spare capacity: The rate of growth of GDP and the size of the output gap. Their main task is to set monetary policy so that AD grows in line with productive potential.
Bank lending and consumer credit figures – including the levels of equity withdrawal from the housing market and also data on credit card lending which supports consumer demand
Equity markets (share prices) and house prices – both are considered important in determining household wealth, which then feeds through to borrowing and retail spending. The monetary policy committee has no official target for the annual rate of house price inflation but it has been criticized for not doing enough to prevent the housing bubble in Britain up to 2008.
Consumer confidence and business confidence – confidence surveys can provide “advance warning” of turning points in the economic cycle. These are called ‘leading indicators’.
Growth of wages, average earnings and unit labour costs – wage inflation might be a cause of cost-push inflation so the Bank of England looks carefully at what is happening to wages
Unemployment figures – and survey evidence on the scale of shortages of skilled labour.
Trends in global foreign exchange markets – a weaker exchange rate could be seen as a threat to inflation because it raises the prices of imported goods and services. A strong exchange rate might bring down inflation but risk causing a deeper economic slowdown via a fall in exports
International data – including recent developments in the Euro Zone, emerging market countries and the United States and Japan.
The key point is that the Monetary Policy Committee considers many indicators from both the demand and the supply-side of the economy.
They then have to make a judgement about what this evidence says about inflationary pressures over a two year forecast horizon.
Why do they have to look up to two years ahead? Because when interest rates are changed, it takes time for them to have an effect on aggregate demand and prices. Uncertain time lags in a world of many external economic shocks make the handling of monetary policy a difficult job!
What are the main effects of changes in interest rates?
Before we look at the impact of rate changes, it is worth remembering that when the Bank is making a decision, there will be lots of other events and policy decisions being made elsewhere in the economy, for example changes in fiscal policy by the government, or perhaps a change in world oil prices or the exchange rate. In macroeconomics the ceteris paribus assumption (all other factors held equal) rarely applies!
- There are several ways in which changes in interest rates influence aggregate demand, output and prices. These are collectively known as the transmission mechanism of monetary policy
- One of the channels that the Monetary Policy Committee in the UK can use to influence aggregate demand, and inflation, is via the lending and borrowing rates charged in the financial markets.
- When the Bank’s own base interest rate goes up, then commercial banks and building societies will typically increase how much they charge on loans and the interest that they offer on savings.
- This tends to discourage businesses from taking out loans to finance investment and encourages the consumer to save rather than spend — and so depresses aggregate demand
- Conversely, when the base rate falls, banks cut the market rates offered on loans and savings and the effect ought to be a stimulus to demand and output.
A key influence played by interest rate changes is the effect on confidence – in particular household’s confidence about their own personal financial circumstances.
Changes in interest rates affect:
- Housing market & house prices:
- Higher interest rates increase the cost of mortgages and reduce the demand for most types of housing. This will affect household wealth and put a squeeze on equity withdrawal (where consumers borrow money secured on rising house prices) which adds directly to consumer spending.
- Effective disposable incomes of mortgage payers:
- If interest rates increase, the income of homeowners who have variable-rate mortgages will fall – leading to a decline in their effective purchasing power
- The effects of a rate change are greater when the level of existing mortgage debt is high as this makes property owners more exposed to higher costs of repaying debts.
- Disposable income of savers:
- A rise in interest rates boosts the disposable income of people who have paid off their mortgage and who have positive net savings in bank and building society accounts
- But if the rate of interest is lower than the rate of inflation, then the annual real return on saving will be negative.
- Consumer demand for credit:
- Higher interest rates increase the cost of paying the debt on credit cards and should lead to a deceleration in retail sales and spending on consumer durables especially items such as cars and household appliances which are typically bought on credit.
- Business capital investment:
- Firms often take the actual and expected level of interest rates into account when deciding whether or not to go ahead with new capital investment spending
- A rise in interest rates may dampen confidence and lead to a reduction in planned capital investment. However, many factors influence investment decisions other than rate changes.
- Consumer and business confidence:
- The relationship between interest rates and business and consumer confidence is complex, and depends crucially on prevailing economic conditions
- For example, when businesses and consumers are worried about the recession, an interest rate cut can boost confidence because it reassures the public that the Bank is alert to the dangers of a slump
- Some people might take emergency interest rate cuts as a sign that the wider economy is in difficulty and hard times lie ahead.
- Interest rates and the exchange rate:
- The link between interest rates and movements in the external value of a currency are important to understand at AS level.
- Higher UK interest rates might lead to an appreciation of the exchange rate particularly if UK interest rates rise relative to those in the Euro Zone and the United States attracting inflows of“hot money” into the British banking system.
- A stronger exchange rate reduces the competitiveness of UK exports in overseas markets because it makes our exports appear more expensive when priced in a foreign currency leading to a decline in export volumes and market share.
- It also reduces the sterling price of imported goods and services leading to lower prices and rising import penetration. If the trade deficit in goods and services widens, this is a net withdrawal of demand from the circular flow and acts to reduce excess demand in the economy.
- A reduction in interest rates and/or an increase in the supply of money and credit in an economy is called an expansionary monetary policy or a reflationary monetary policy
- An increase in interest rates and/or attempts to control or reduce the supply of money and credit is called a contractionary monetary policy or a deflationary monetary policy
- Over the last few decades, monetary policy has been the main policy instrument for managing the level and rate of growth of aggregate demand and inflationary pressures
Monetary Policy Asymmetry
- Fluctuations in interest rates do not have a uniform impact on the economy. Some industries are more affected by interest rate changes than others, for example exporters and industries connected to the housing market. And, some regions are also more sensitive to a change in the direction of interest rates.
- The markets and businesses most affected by changes in interest rates are those where demand is interest elastic in other words, demand responds elastically to a change in interest rates or indirectly through changes in the exchange rate
- Good examples of interest-sensitive industries include those directly linked to the housing market¸ exporters of manufactured goods, the construction industry and leisure services
- In contrast, the demand for basic foods and utilities is less affected by short term fluctuations in interest rates and is affected more by changes in commodity prices such as oil and gas.
Ultra low interest rates in the UK from 2009-2012
- The Bank of England started cutting monetary policy interest rates in the autumn of 2008 as thecredit crunch was starting to bite and business and consumer confidence was taking a huge hit. By the start of 2009 rates were down to 3% and they carried on falling
- By the summer of 2009 the policy interest rate in the UK was 0.5% and the Bank of England had reached the point of no return when it comes to cutting interest rates
- The decision to reduce official base rates to their minimum was in response to evidence of a deepening recession and fears of price deflation
- Ultra-low interest rates are an example of an expansionary monetary policy i.e. a policy designed to deliberately boost aggregate demand and output. At the time of writing (August 2012) official base interest rates have stayed at 0.5% for over two and a half years and there are few signs that they will increase significantly in the near term.
In theory cutting interest rates close to zero provides a big monetary stimulus – this means that:
- Mortgage payers have less interest to pay – increasing their effective disposable income
- Cheaper loans should provide a possible floor for house prices in the property market
- Businesses will be under less pressure to meet interest payments on their loans
- The cost of consumer credit should fall encouraging the purchase of big-ticket items such as a new car or kitchen
- Lower interest rates might cause a depreciation of sterling thereby boosting the competitiveness of the export sector
- Lower rates are designed to boost consumer and business confidence
But some analysts argue that in current circumstances, a period of low interest rates has little impact on demand. Several reasons have been put forward for this:
- The unwillingness of banks to lend – most banks have become risk-averse and they have cut the size of their loan books and making credit harder to obtain
- Low consumer confidence – people are not prepared to commit to major purchases because the recession has made people risk averse. Weak expectations lower the effect of rate changes on consumer demand – i.e. there is a low interest elasticity of demand.
- Huge levels of debt still need to be paid off including over £200bn on credit cards
- Falling or slowing rise asset prices makes it unlikely that cheap mortgages will provide an immediate boost to the housing market.
- Although official monetary policy interest rates are now close to zero, the rate of interest charged on loans and overdrafts has actually increased – the cost of borrowing using credit cards and bank loans is a high multiple of the policy rate. Little wonder that many smaller businesses have complained that the Bank of England’s policy of ‘cheap money’ has done little to improve their situation during the recession and in the early stages of the recovery.
- In March 2009 the Bank of England started a policy of quantitative easing (QE) for the first time. QE is also called as ‘asset purchase scheme’ or a ‘bond purchase scheme’
- The aim of QE is to support demand in the economy and prevent a period when inflation is persistently below target or becomes negative (deflation).
- The Bank of England can use QE to increase the supply of money in the banking system.
- The media call this ‘printing money’ but this is only true in an electronic sense – the Bank does not actually print new £10, £20 and £50 notes in an attempt to inject cash into the economic system.
- Under this ‘unconventional strategy’, the MPC discusses each month how many assets, including government bonds, to buy with central bank money. This money is simply created by the central bank and is the equivalent of turning on the printing press.
- Quantitative easing has been used by other central banks including the USA Federal Reserve
- There are doubts about the effectiveness of quantitative easing – bank lending has struggled to recover since the end of the recession despite bond purchases totalling £375bn as of July 2012
Funding for Lending Scheme (FLS)
This was introduced in 2012 as a new policy designed to increase the supply of credit in the British economy. The FLS offers banks and other lenders cheap funding (lower interest rates) secured against some of their assets (known as collateral) if they agree to lend on to businesses and home-buyers.
Some Evaluation Points on Interest Rates
- Time lags should always be considered when analyzing the effects of interest rate changes.
- Monetary policy is not an exact science – what happens in the macro-economy is the result of millions of decisions taken by households and businesses. We cannot predict with great accuracy the extent to which a change in interest rates will achieved the desired / planned economic effects
- When it comes to inflation targeting there are many factors affecting costs and prices and most of these are outside of the Bank of England’s direct control e.g. changes in international commodity prices and fluctuations in the exchange rate (see the next chapter)
- Monetary policy does not work in isolation! Always remember consider how the government’s fiscal policy is affecting demand and inflationary pressures.
- Changes in interest rates can have an important effect on the distribution of income and wealthin a country. This is discussed briefly below:
Interest rates and the distribution of income and wealth
Consider the effect of a fall in interest rates throughout an economy
- The real income of savers:
- If the rate of interest paid on savings falls below the rate of inflation, then people with positive net savings will see a reduction in their real incomes
- This has become a major policy issue in recent years with interest rates on deposit accounts collapsing in the UK. Rising inflation and falling interest rates have dealt a double-blow to millions of savers many of whom are older and reliant on savings as a source of income. The return is even lower when we consider that most savers pay 20% tax on any interest. Some pay 40% or 50% on their savings interest.
- The disposable incomes of mortgage-payers:
- If interest rates fall, the income of home-owners who have variable-rate mortgages will increase – leading to an rise in their purchasing power
- Interest rates, house prices and wealth:
- Many factors affect house prices but when the cost of a mortgage falls, standard theory predicts that the demand for housing will expand driving property values higher.
- This increases the net financial wealth of people who own property but makes it more difficult for lower-income families including many young people to find the money to afford to purchase a house or flat.
In summary – when interest rates fall, there is a re-distribution of income away from lenders (who receive less) towards those with variable rate loans.
People with positive net savings also stand to lose out from big cuts in interest rates. Little wonder that the Governor of the Bank of England gets many letters of complaints from pensioners when interest rates are cut or remain low for long periods of time!
Managing the Economy – Government Fiscal Policy
Fiscal policy involves the use of government spending, taxation and borrowing to affect the level and growth of aggregate demand, output and jobs
In Singapore, the long-term objectives of government budgetary policy are:
- to promote and support sustained, non-inflationary economic growth;
- to maintain a balanced budget, i.e. to finance total operating and development expenditures from operating revenue over the course of the business cycle; and
- to focus government expenditure on delivering essential public goods and services, e.g. education, healthcare, infrastructure, housing and programmes to protect the environment.
Underlying the above objectives are the recognition of market forces in driving the economy, financial prudence and emphasis on human & infrastructure investment.
Tax policy is an integral part of fiscal policy. The main objectives of tax policy in Singapore are:
- Revenue RaisingThis is the traditional aim of tax policy. Tax revenue is a substantial source of funding for government operations.
- Promotion of Economic and Social GoalsTax has been used to influence behaviour towards desirable social and economic goals. For instance, to encourage mechanisation and automation, the government allows accelerated capital allowance for most assets used for business purposes. To encourage Singaporeans to have more children, tax rebates are given for the first to fifth child(ren).
The fundamental tenet of Singapore’s tax policy is to keep tax rates competitive both for corporations as well as individuals. Keeping our corporate rate competitive will help us to continue to attract a good share of foreign investment. Keeping our individual rates low will encourage our people to work hard. It will also make risk-taking worthwhile and encourage entrepreneurship.
To increase the resilience of taxes as a source of government revenue, Goods & Services Tax (GST) was introduced in 1994. This balanced mix of tax on consumption and income reduces the vulnerability of revenue intake to adverse changes in economic conditions and strengthens the resilience of Singapore’s fiscal position.
Government Operating Revenue
There are three main sources of government operating revenue, namely tax revenue, fees and charges and other receipts. Tax revenue accounts for 74.1% of the government operating revenue for the financial year 2012/13. The most significant is tax revenue from the various taxes imposed by the government, which are as follows.
- Income TaxIncome tax is chargeable on income of individuals and companies.
- Property TaxProperty tax is imposed on owners of properties based on the expected rental values of the properties.
- Estate Duty (Removed for deaths occuring on or after 15 Feb 2008)Estate duty is levied on the value of a deceased’s net assets in excess of a threshold amount.
- Motor Vehicle TaxesThese are taxes, other than import duties, that are imposed on motor vehicles. These taxes are imposed to curb car ownership and road congestion.
- Customs & Excise DutiesSingapore is a free port and has relatively few excise and import duties. Excise duties are imposed principally on tobacco, petroleum products and liquors. Also, very few products are subject to import duties. The duties are mainly on motor vehicles, tobacco, liquor and petroleum products.
- Goods & Services TaxGST is a tax on consumption. The tax is paid when money is spent on goods or services, including imports.
- Betting TaxesThese are duties on private lottery, betting & sweepstake.
- Casino Tax
The casino tax is a new tax levied on the casinos’ gross gaming revenue.
- Stamp DutiesThis is imposed on commercial and legal documents relating to stock & shares and immovable property.
- OthersThe two main taxes are the foreign worker levy and the airport passenger service charge. The foreign worker levy is imposed to regulate the employment of foreign workers in Singapore.
IRAS is responsible for collecting income tax, property tax, goods & services tax, estate duty (for deaths occuring before 15 Feb 2008), betting taxes and stamp duty.
Fiscal policy is also used to change the pattern of spending on goods and services
It is also a means by which a redistribution of income & wealth can be achieved
It is an instrument of intervention to correct for free-market failures
Changes in fiscal policy affect aggregate demand (AD) and aggregate supply (AS)
Fiscal Policy and Aggregate Demand
Traditionally fiscal policy has been seen as an instrument of demand management. This means that changes in government spending, direct and indirect taxation and the budget balance can be used“counter-cyclically” to help smooth out some of the volatility of national output particularly when the economy has experienced an external shock and is in a recession.
- The Keynesian school argues that fiscal policy can have powerful effects on demand, output and employment when the economy is operating below full capacity national output, and where there is a need to provide a demand-stimulus.
- Monetarist economists believe that government spending and tax changes only have a temporary effect on aggregate demand, output and jobs and that the tools of monetary policy are a more effective instrument in controlling inflation and maintaining macroeconomic stability
The fiscal policy transmission mechanism
This flow-chart identifies some of the channels involved with the fiscal policy transmission mechanism – in the example shown we focus on an expansionary fiscal policy designed to boost demand and output
The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the economy has; how much of any increase in disposable income is spent rather than saved or spent on imports. And also the effects of fiscal policy on variables such as interest rates
A contractionary fiscal policy would involve one or more of the following:
- A cut in government expenditure either in real terms or as a share of GDP
- An increase in direct and/or indirect taxes
- An attempt to reduce the size of the budget deficit
Government spending (or public spending) and in Singapore, it takes up over 15% of GDP. Spending by the public sector can be broken down into three main areas:
- Transfer Payments:
- These are welfare payments made available through the social security system including Child Benefit, Student Grants, Housing Grants, Income Support and Tax Credit
- Current Government Spending: i.e. spending on state-provided goods & services that are provided on a recurrent basis – for example salaries paid to people working in the Civil Service and resources for state education and defence. The Civil Service/ Public Service Division is the country’s biggest employer with over 136000 people working within the system!
- Capital Spending: Capital spending includes infrastructure spending such as new motorways and roads, hospitals, schools and prisons. This investment spending adds to the economy’s capital stock and can have important demand and supply side effects in the long term.
Economic and Social Justifications for Government Spending
- To provide a socially efficient level of public goods and merit goods and overcome market failure
- Public goods and merit goods tend to be under-provided by the private sector
- Improved and affordable access to education, health, housing and other public services can help to improve human capital, raise productivity and generate gains for society as a whole
- To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society – this is also part of the process of redistributing income and wealth. Government spending has an important role to play in controlling / reducing the level of relative poverty
- To provide necessary infrastructure via capital spending on transport, education and health facilities – an important component of a country’s long run aggregate supply
- Government spending can be used to manage the level and growth of AD to meet macroeconomic policy objectives such as low inflation and higher levels of employment
Government spending can be justified as a way of promoting equity. Well targeted and high value for money public spending is also a catalyst for improving economic efficiency and macro performance.
- Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, inheritance tax, national insurance contributions, capital gains tax, and corporation tax.
- Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and Goods and Services Tax (GST ) on many different goods and services
refer to below link for the various tax rates in Singapore
Automatic stabilisers and discretionary changes in fiscal policy
Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending – for example, increased capital spending on roads or more resources going into the PSD.
Automatic stabilisers are changes in tax revenues and government spending that come about automatically as an economy moves through the business cycle
Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which takes money out of the circular flow of income and spending
Welfare spending: A growing economy means that the government does not have to spend as much on means-tested welfare benefits such as income support and unemployment benefits
Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of money from the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a larger budget deficit.
Fiscal Policy and Aggregate Supply
It is important to understand that fiscal policy can have important effects on the supply-side of the economy. Indeed many government fiscal decisions are made with improving the supply-side in mind.
- Labour market incentives:
- Changes in income tax can improve incentives for people to actively look for work
- Lower taxes might also have a positive effect on work effort and labour productivity
- Cuts to national insurance contributions might help to expand the active labour supply
- Some economists argue that welfare benefit reforms are more important than tax cuts in improving incentives – to create a gap between the incomes of people in a job and the unemployed. Some people favour reducing the relative value of benefits as a way of improving incentives. Others favour a move towards targeted benefits where the transfer payment is linked to participation in employment schemes or community work
- Capital spending:
- Spending on infrastructure (e.g. improvements to our motorway network or an increase in the building programme for new schools and hospitals) helps provide the capacity needed for other businesses to flourish.
- Lower rates of corporation tax and other business taxes might attract inward investment from overseas. An aim of the Singapore government is to have the lowest corporate tax rate
- Entrepreneurship and investment:
- Government spending can be used to fund an expansion in new small business start-ups
- Research and development and innovation:
- Government spending, tax credits and other tax allowances could be used to encourage research and development to improve competitiveness and contribute to a faster pace of innovation and invention
- A key aim going forward is to use tax incentives to stimulate an increase in investment in low carbon technologies to promote green growth
- Human capital of the workforce:
- Spending on education and increased investment in health and transport can also have important supply-side effects in the long run
- Government spending on youth apprenticeships can help to improve human capital, employability and productivity – giving more younger people the chance to make a strong start when they enter the labour market
The Free Market Agenda
Free market economists are sceptical of the effects of government spending in improving the supply-side of the economy. They argue that lower taxation and tight control of government spending and borrowing is required to allow the private sector of the economy to flourish. They believe in a smaller sized state sector so that in the long run, the overall burden of taxation can come down and thus allow the private sector of the economy to grow and flourish.
Economics of a Budget (Fiscal) Deficit
- When the government is running a budget deficit, it means that in a given year, total government expenditure exceeds total tax revenue
- If the government is running a budget deficit, it has to borrow this money through the issue of debt such as Treasury bills and bonds
- Most of the government debt is bought up by financial institutions but individuals can buy bonds, premium bonds and buy national savings certificates
- The budget balance is the annual difference between tax revenues and government spending
- Gross government debt is the total accumulated debt owed by the government – this is also known as the national debt
Does a budget deficit matter?
A persistently large budget deficit can be a problem:
- Financing a deficit:
- If the budget deficit rises to a high level, the government may have to offer higher interest rates to attract sufficient buyers of debt.
- This raises the possibility of the government falling into a debt trap where it must borrow more to repay the interest on accumulated borrowing.
- Many high debt countries in the European Union have suffered from this in recent years – high profile examples have included Ireland, Greece, Spain and Portugal.
- A government debt mountain:
- Annual budget deficits over a number of years will cause the total amount of unpaid government debt to climb.
- There is an opportunity cost involved because interest payments on bonds might be used in more productive ways, for example on health services or extra investment in education.
- Higher public sector debt also represents a transfer of income from people and businesses that pay taxes to those who hold government debt and cause a redistribution of income and wealth in the economy.
- If a larger budget deficit leads to higher interest rates and taxation in the medium term and thereby has a negative effect on growth in consumption and investment spending, then a process of ‘fiscal crowding-out’ is occurring
- For example, the Institute of Fiscal Studies has estimated that reducing the UK budget deficit over the next five years will require every person in the UK to pay £1250 of extra taxes each year.
- Risk of capital flight:
- Some economists believe that high borrowing risks causing a ’run on a domestic currency’. This is because the government may find it difficult to find sufficient buyers of its debt and the credit-rating agencies may decide to reduce the rating on a nation’s sovereign debt
Potential benefits of a budget deficit
- Government borrowing can benefit growth:
- A budget deficit can have positive macroeconomic effects if it is used to finance capital spending that leads to an increase in the stock of national assets
- For example, spending on transport infrastructure improves the supply-side capacity and productivity of the economy
- Improved provision of public goods can create positive externalities
- The budget deficit as a tool of demand management:
- Keynesian economists support borrowing as a way of managing aggregate demand
- An increase in borrowing can be a useful stimulus to demand when other sectors of the economy are suffering from weak or falling spending
- A change in the government budget deficit may lead to a more than proportional change in aggregate demand – this is known as the fiscal multiplier effect.
Cutting the deficit – Austerity Measures
- The Coalition Government in Britain wants to halve the budget deficit over a five year period
- They have launched a programme of fiscal austerity amounting to £126 billion a year of combined spending cuts and tax rises
- Most of the fiscal austerity is coming through planned reductions in the real level of government spending. 80% will come from spending reductions, 20% is forecast to come from higher taxes
- The “fiscal squeeze” is highly controversial and has led to an impassioned debate among economists about the best way to control a budget deficit as an economy struggles to lift itself out of recession and sustain a recovery.
- Keynesian economists argue that deficit-reduction policies risk driving the economy into a second recession – known as a double-dip. Reducing spending or raising taxes could hurt an already fragile economy and make the fiscal deficit problem even worse. They doubt whether new job creation in the private sector is likely to be able to compensate for job losses in the public sector.
- Keynesians believe that economic growth will help bring down the deficit and that maintaining a sufficiently high level of demand is crucial to achieving this – public expenditure is a component of aggregate demand and hence if public expenditure falls so will aggregate demand C+I+G+X-M). Many private sector jobs depend on public sector spending, for example workers in the construction industry who build new roads or social housing.
The government believes that reducing the budget deficit is possible without causing another downturn and that cutting the budget deficit is important to maintain their economic credibility in financial markets. Cuts in public spending are unavoidable given the size of the budget deficit. Their strategy relies less heavily on tax increases; indeed some taxes have been cut in a bid to stimulate private sector investment.
Exchange Rates Policies
The exchange rate measures the external value of sterling in terms of how much of another currency it can buy.
The value of the currency is determined in the foreign exchange market where billions of $s of currencies are traded every hour.
The main traders are businesses, international investors and governments
Overview of MAS
Who We Are
MAS is the central bank of Singapore. Our mission is to promote sustained non-inflationary economic growth, and a sound and progressive financial centre.
To act as the central bank of Singapore, including the conduct of monetary policy, the issuance of currency, the oversight of payment systems and serving as banker to and financial agent of the Government
To conduct integrated supervision of financial services and financial stability surveillance
To manage the official foreign reserves of Singapore
To develop Singapore as an international financial centre
History of MAS
Prior to 1970, the various monetary functions associated with a central bank were performed by several government departments and agencies. As Singapore progressed, the demands of an increasingly complex banking and monetary environment necessitated streamlining the functions to facilitate the development of a more dynamic and coherent policy on monetary matters. Therefore in 1970, Parliament passed the Monetary Authority of Singapore Act leading to the formation of MAS on 1 January 1971. The passing of the MAS Act gave MAS the authority to regulate the financial services sector in Singapore.
The MAS has been given powers to act as a banker to and financial agent of the Government. It has also been entrusted to promote monetary stability, and credit and exchange policies conducive to the growth of the economy.
In April 1977, the Government decided to bring the regulation of the insurance industry under the wing of the MAS. The regulatory functions under the Securities Industry Act (1973) were also transferred to MAS in September 1984.
The MAS now administers the various statutes pertaining to money, banking, insurance, securities and the financial sector in general. Following its merger with the Board of Commissioners of Currency on 1 October 2002, the MAS has also assumed the function of currency issuance.
Monetary Policy and Economics
The Monetary Authority of Singapore (MAS) carries out the full range of central banking functions related to the formulation and implementation of monetary policy.
MAS’ monetary policy objective is price stability over the medium-term as the basis of sustainable economic growth. As monetary policy in Singapore is centred on the management of the trade-weighted exchange rate, MAS carries out foreign exchange operations to ensure that the Singapore dollar nominal effective exchange rate remains within the policy band.
MAS also conducts money market operations to provide sufficient liquidity for a well-functioning banking system and to meet banks’ demand for reserve and settlement balances.
Managed Floating and Intermediate Exchange Rate Systems: The Singapore Experience
This staff paper (PDF, 234KB) examines the key characteristics of Singapore’s exchange rate-centred monetary policy; in particular, its managed float regime which incorporates key features of the basket, band and crawl system.
Floating exchange rates (Example UK)
What does a weak pound tell us?
As the pound has dropped in value against other major currencies like the dollar and euro, travelling abroad has become much more expensive. Imported goods have also pushed up basic prices for British firms and consumers. UK exporters, however, has welcomed the weaker pound as it makes their goods cheaper to foreign markets. Economists have welcomed the weakening of sterling as heralding a much-needed correction to the UK’s chronic trade imbalances. However, as the pound can be seen as a barometer of the UK economy, some perceive its recent weakening as a matter of concern.
Source: News Reports, Feb 2011
The UK operates with a floating exchange rate system where the forces of market demand and supply determine the daily value of one currency against another
The value of the pound depends in how strong is demand for the currency relative to supply
If overseas investors want to buy into sterling to take advantage of higher interest rates on offer in UK bank accounts, they will swap their own currencies for pounds. This causes an increase in the demand for sterling in the foreign exchange markets, and in the absence of other offsetting factors, this will cause an appreciation.
Currencies tend to go up in value either when a country is running a large trade surplus – which brings in extra demand for a currency from sales of exports – or when overseas investors regard the currency as a good one to buy. This might be because attractive interest rates are on offer by putting money into savings accounts in that currency. Or because there are high expected returns from other types of investment notably property, stocks and shares and so on.
How does a change in the exchange rate influence the economy?
- Changes in the exchange rate can have powerful effects on the macro-economy affecting variables such as the demand for exports and imports; real GDP growth, inflation, business profits and jobs
- As with most variables in economics, there are time lags involved. The impact of movements in currencies on the economy depends in part on:
- The scale of any change in the exchange rate i.e. a 5%, 10% or even larger movement
- Whether the change in the currency is short-term or long-term – i.e. is the change in the exchange rate temporary or likely to persist for some time?
- How businesses and consumers respond to exchange rate fluctuations – price elasticity of demand is important here i.e. will there be a large change in demand for exports and imports?
- The size of any multiplier and accelerator effects
- When the currency movement takes place – i.e. at which point of an economic cycle
How can changes in the exchange rate affect the rate of inflation?
The exchange rate affects the rate of inflation in a number of direct and indirect ways:
- Changes in the prices of imports – this has a direct effect on the consumer price index. For example, an appreciation of the exchange rate usually reduces the sterling price of imported consumer goods and durables, raw materials and capital goods.
- Commodity prices and the CAP: Many commodities are priced in US dollars – so a change in the sterling-dollar exchange rate has a direct impact on the UK price of commodities such as foodstuffs. A stronger dollar makes it more expensive for Britain to import these items.
Changes in the growth of UK exports: A higher exchange rate makes it harder to sell overseas because of a rise in relative UK prices. If exports slowdown (price elasticity of demand is important in determining the scale of any change in demand), then exporters may choose to cut their prices, reduce output and cut-back employment levels.
Bank of England research suggests that a10% depreciation in the exchange rate can add up to 3% to the level of consumer prices three years after the initial change in the exchange rate. But the impact on inflation of a change in the exchange rate depends on what else is going on in the economy. For example a lower pound is unlikely to have the same inflationary effects during a recession.
The chart above shows the effective exchange rate index for sterling (a trade-weighted measure of the buying power of sterling against a basket of international currencies) and the annual average rate of consumer price inflation in the UK
Why the pound is crucial to the economy?
The exchange rate is the price of one currency expressed in terms of another and is crucial to businesses selling goods and services abroad as well as those firms who import products from other countries. When the exchange rate rises in value (i.e. an appreciation), this makes exporters’ goods, priced in sterling, more expensive in foreign currency. So demand for these dearer exports can be expected to fall, depending on the price elasticity of demand for UK exports and also whether there have been changes in other factors influencing demand.
A decline in exports reduces overall aggregate demand and should lower inflationary pressure – so a higher exchange rate could lead to the Monetary Policy Committee deciding to reduce official base interest rates.
A higher exchange rate also makes imports cheaper when sold in the UK. This is good news for the real purchasing power of British consumers, and also for UK firms who need to import raw materials, components and finished products. But higher prices feed into the consumer price index and can have a direct effect on our rate of inflation.
So a strong pound is good news for keeping inflation under control, but can have negative effects on exports which account for around thirty per cent of aggregate demand. A weaker pound can provide a boost to aggregate demand, a useful tool in lifting the economy out of a recession.
Evaluation points on the effects of exchange rate changes
Changes in the exchange rate have quite a powerful effect on the economy but we tend to assume ceteris paribus – all other factors held constant – which of course is highly unlikely to be the case
Counter-balancing use of fiscal and monetary policy: For example the government can alter fiscal policy to manage AD
Time lags – it takes time for demand for exports and imports to change following a movement in the currency. Businesses need to have the capacity and access to credit to expand their production.
Low elasticities of demand: In the short term, the effects of exchange rates on export and import demand tends to be low because of low price elasticity of demand
Business response to the challenge of a high exchange rate: Businesses can and do adapt to a high exchange rate. There are several ways in which industries can adjust to the competitive pressures that a strong pound imposes. Some of the options include:
Cutting their export prices when selling in overseas markets and therefore accepting lower profit margins to maintain competitiveness and market share
Out-sourcing components from overseas to keep production costs down
Seeking productivity / efficiency gains to keep unit labour costs under control or perhaps trying to negotiate a reduction in pay levels
Investing extra resources in new product lines where demand is price inelastic and less sensitive to exchange rate fluctuations. This involves producing products with a higher income elasticity of demand, where non-price factors such as product quality, design and effective marketing are as important in securing orders as the actual price.
Supply-side Economic Policies
The “supply side” refers to factors affecting the quantity or quality of goods and services produced by an economy such as the level of productivity or investment in research and development.
What are supply-side policies?
- Supply-side policies are mainly micro-economic policies designed to make markets and industries operate more efficiently and contribute to a faster underlying-rate of growth of real national output
- Successful policies have the effect of shifting the LRAS curve to the right leading to a rise in potential output
- Most governments believe that improved supply-side performance is the key to achieving sustained growth without causing a rise in inflation.
- Supply-side reform on its own is not enough to achieve this growth. There must also be a high enough level of AD so that the productive capacity of an economy is actually brought into play.
Key concepts to focus on are incentives, enterprise, technology, mobility, flexibility and efficiency.
- Improve incentives and invest in people’s skills
- Increase labour and capital productivity
- Increase the occupational and geographical mobility of labour
- Increase capital investment and research and development spending by firms
- Promoting more competition and stimulate a faster pace of invention and innovation
- Provide a platform for sustained non-inflationary growth of an economy
- Encourage the start-up and expansion of new businesses / enterprises
Different approaches to the supply side
- Cutting government spending and taxes and policies to cut government borrowing
- Laws to control trade union powers
- Reducing red-tape to cut the costs of doing business
- Measures to improve the flexibility of the labour market / reforming employment laws
- Policies to boost competition such as deregulation and tough anti-monopoly and anti-cartel laws
- Privatisation of state assets (selling off public sector businesses into the private sector)
- Opening up an economy to overseas trade and investment
- Opening up an economy to inward labour migration
- State has key role in investing in public services and building critical infrastructure
- Tax incentives and welfare reforms can encourage more people into work
- A commitment to a fair minimum wage / living wage to improve work incentives
- Active regional policy to boost under-performing areas / areas of high unemployment
- Some case for selective import controls to allow domestic industries to expand
- Management of the exchange rate to improve competitiveness of export industries
- Nationalisation of some key industries
- Stronger regulation of industries including finance and transport
There are two broad approaches to the supply-side. Firstly policies focused on product markets where goods and services are produced and sold to consumers and secondly the labour market – a factor market where labour is bought and sold
Product Market Reforms
- Product markets refer to markets in which all kinds of goods and services are made and traded, for example the market for airline travel; smart-phones, new cars; pharmaceutical products and the markets for financial services such as banking, mortgages and pensions.
- Supply-side policies in product markets are designed to increase competition and efficiency
Deregulation of Markets
- De-regulation or liberalisation means the opening up of markets to greater competition
- The aim of this is to increase market supply (driving prices down) and widen the choice available to consumers
- Good examples of deregulation to use include: urban bus transport, post and parcel delivery service, telecommunications, and gas and electricity supply.
Toughening up of Competition Policy
- Most supply-side economists believe that competition forces business to become more efficient in the way in which they use scarce resources.
- A tougher competition policy regime includes policies designed to curb anti-competitive practices such as price-fixing cartels and other abuses of a dominant market position – in other words – intervention to curb some of the market failure that can come from monopoly power
A commitment to free (open) trade
- Trade between nations creates competition and should be a catalyst for improvements in costs and lower prices for consumers
Measures to encourage small business start-ups / entrepreneurship
- The small businesses of today often become the larger businesses of tomorrow employing more workers and contributing to innovation that can have positive spill-over effects in other industries.
- Governments of all political persuasions argue that they want to promote an entrepreneurial culture and to increase the rate of new business start-ups.
- Supply side policies include loan guarantees for new businesses; regional policy assistance for entrepreneurs in depressed areas of the country; advice for new firms
Capital investment and innovation:
- Capital spending by firms adds to aggregate demand (C+I+G+(X-M)) but also has an important effect on long run aggregate supply.
- Supply side policies would include tax relief on research and development and reductions in the rate of corporation tax
Supply side policies for the Labour Market
- These policies are designed to improve the quality and quantity of the supply of labour available to the economy
- They seek to make the labour market more flexible so that it is better able to match the labour force to the demands placed upon it by employers in expanding sectors thereby reducing the risk of structural unemployment.
- An expansion in the labour supply increases the productive potential of an economy.
- That expansion in the supply of people willing and able to work can come from several sources for example: encouraging older people to stay in the workforce; a relaxed approach to labour migration and measures to get non-working parents to actively look for work.
Structural Weaknesses in the Labour Market
Increased Spending on Education and Training
Economists disagree about the scale of the likely economic and social returns to be earned from higher spending on education – but few of them deny that “investment in education” has the potential to raise the skills within the work force and improve the employment prospects of thousands of unemployed workers.
- The economic returns from extra education spending vary according to the stage of development that a country has achieved
- Government spending on education and training improves workers’ human capital
- Economies that have invested heavily in education are those that are well set for the future. Most economists agree, with the move away from industries that required manual skills to those that need mental skills, that investment in education, and the retraining of previously manual workers, is vital.
- Improved training, especially for those who lose their job in an old industry should improve the occupational mobility of workers. This should help reduce the problem of structural unemployment.
- A well-educated workforce acts as a magnet for foreign investment in the economy.
- Improved education increases opportunities which means that incentives can work more effectively
Income Tax Reforms and the Incentive to Work
- Economists who support supply-side policies believe that lower rates of income tax provide a short-term boost to demand, and they improve incentives for people to work longer hours or take a new job – because they get to keep more of the money they earn.
- Cutting tax rates for lower paid workers may help to reduce the extent of the ‘unemployment trap’ – where people calculate that they may be no better off from working than if they stay outside the labour force.
- Do lower taxes always help to increase the active labour supply in the economy? It seems obvious that lower taxes should boost the incentive to work because tax cuts increase the reward from a job. But some people may choose to work the same number of hours and simply take a rise in their post-tax income! Millions of other workers have little choice over the hours that they work.
Showing the effects of supply-side improvements in the economy
- Supply-side factors often help to explain why it is that some countries grow faster than others
- In a world of globalisation, it is becoming clearer that maintaining and improvingcompetitiveness is vital in achieving success in international markets.
- A rising share of GDP in most countries is devoted to international trade. Markets are becoming more competitive and those countries whose supply-side lets those down can find a rising level of import penetration into their domestic markets and a weak export performance in goods and services.
How can supply-side policies help lift a country out of recession?
- Recessions are often the result of negative demand-side shocks that hit real incomes of consumers and demand and profits for businesses
- The consequences show through in higher unemployment, a fall in capital investment and an increasing rate of business failures
- There is a danger that a deep recession and slow recovery will have harmful effects on the supply side leading to a reduction in the growth rate of potential GDP and a loss of productive capacity
- This is known as a hysteresis effect
- Most macroeconomic policies in a recession centre on boosting demand and confidence in a bid to generate a rebound in output, jobs and incomes within the circular flow and prevent hysteresis
The chart above provides an illustration of the damaging effects of a recession. 2009 was a year of recession and as a result employment contracted and the unemployment rate jumped sharply. There has been a modest recovery in employment since 2009 but unemployment has continued to climb. The estimated trend growth rate for the UK has declined and this suggests that the economy will struggle to achieve a strong recovery.
What role can supply-side policies play during an economic downturn?
- Extra capital spending on an economy’s critical infrastructure – this might be funded by the government for example bringing forward some investment spending on hospital re-building, transport projects and environmental schemes. Other big capital spending projects might be partly financed by the private sector perhaps as part of a public-private partnership. These projects are often labour-intensive and can create a sizeable multiplier effect
- Reductions in business taxation – for example lowering the rate of corporation tax (to stimulate investment) or reducing employers’ national insurance contributions (to boost the demand for labour). Lower taxes for business research and development spending or tax relief for inward investment projects also have a supply-side aspect to them
- Policies designed at improving the quality of and access to education and training for all. This is particularly relevant when coming out of a recession because many of the new jobs in an economy as recovery gathers momentum are not in the same industries as before a downturn. It is hugely important to prevent cyclical unemployment from turning into structural unemployment
- Measures to stimulate business start-ups – seed-corn finance and other help for new enterprises can provide a flow of new jobs as an economy picks up
- Relaxation of planning controls designed to increase the rate of new house-building
- Policies to maintain the openness to trade and investment from overseas – instead of choosing protectionist policies, politicians should understand the importance of trade and competition as a means of generating new demand and creating extra jobs.
- Productivity is a measure of the efficiency with which a country combines capital and labour to produce more with the same level of factor inputs. We commonly focus on labour productivity measured by output per person employed or output per person hour.
- A better measure of productivity growth is total factor productivity which takes into account changes in the amount of capital to use and also changes in the size of the labour force.
- To give a numerical example, if the size of the capital stock grows by 3% and the employed workforce expands by 2% and output (GDP) increases by 8%, then total factor productivity has increased by 3%.
Productivity is an important determinant of living standards – it quantifies how an economy uses the resources it has available, by relating the quantity of inputs to output. As the adage goes, productivity isn’t everything, but in the long run it’s almost everything. Higher productivity can lead to:
- Lower unit costs: These cost savings might be passed onto consumers in lower prices, encouraging higher demand, more output and an increase in employment.
- Improved competitiveness and trade performance: Productivity growth and lower unit costs are key determinants of the competitiveness of firms in global markets.
- Higher profits: Efficiency gains are a source of larger profits for companies which might be re-invested to support the long term growth of the business.
- Higher wages: Businesses can afford higher wages when their workers are more efficient.
- Economic growth: If an economy can raise the rate of growth of productivity then the trend growth of national output can pick up.
- Productivity improvements mean that labour can be released from one industry and be made available for another – for example, rising efficiency in farming will increase production yields and provide more food either to export or to supply a growing urban population.
- If the size of the economy is bigger, higher wages will boost consumption, generate more tax revenue to pay for public goods and perhaps give freedom for tax cuts on people and businesses.
Research and Development (R&D)
Spending on research and development (R&D) in Singapore has remained low as a % of GDP
- This ‘research gap’ is a constraint on innovation and affects global competitiveness
- Other countries e.g. Finland, Germany and Israel devote higher share of GDP to research
- The biggest barriers to innovation are risk aversion, uncertainty about ability to exploit research and make a profit, a lack of high-skilled workers and a lack of information on technology and markets
- There is some evidence of higher R&D spending in the Sg among smaller businesses in computing technology, biotechnology and medicine
- Research is important for supply-side competitiveness but a key evaluation point is that the level of research spending is not necessarily a guide to the pace and success of innovation in a country.
- Many businesses do not patent all their most innovative ideas, preferring instead to keep them as trade secrets
- Steve Jobs once said, “Innovation has nothing to do with how many R&D dollars you have. When Apple came up with the Mac, IBM was spending at least 100 times more on R&D.”
Measures of International Competitiveness
Competitiveness is the ability of an economy to compete fairly and successfully in markets for internationally traded goods and services that allows for rising standards of living over time.
- Cost competitiveness – differences in unit costs between producers – reflected in prices
- Non-price competitiveness – this encompasses technical factors such as product quality, design, reliability and performance, choice, after-sales services, marketing, branding and the availability and cost of replacement parts
Unit labour costs
- These are the labour costs of supplying goods and services per unit of output – in simple terms, how expensive it is to make something
- Unit labour costs are determined by
- The costs of employing people (wage rates, salaries, payroll taxes)
- The productivity of these people
- Data on unit labour costs is normally expressed in relative terms i.e. we compare unit labour costs in one country relative to another
- Unit labour costs will rise when wages rise faster than the annual improvement in productivity
These are also important when it comes to sustaining an improvement in competitiveness in global markets. The main non wage costs for businesses:
- The costs of meeting environmental regulations
- Environmental taxes
- Employment protection laws and health and safety laws
- Requirements to provide business pensions
World Economic Forum – Global Competitiveness Report
This is a report published annually and is an attempt to rank countries using a group of indicators.
- Institutions (property rights protection, trust, judicial independence, corruption)
- Infrastructure (transport, telephony, and energy, ports)
- Macroeconomic environment (including stability of key macro indicators)
- Health and primary education, Higher education and training
- Goods market efficiency, labour market efficiency
- Financial markets (including stability of markets, strength of banks)
- Technological readiness (readiness to exploit, adapt to new technologies)
- Market size (linked to population size and per capita incomes)
- Business sophistication (quality of supply chains, industrial clusters, quality of management)
SG ranking in global competitiveness:
Singapore still 2nd most competitive economy: World Economic Forum
Switzerland has kept its title as the world’s most competitive economy for the fifth year running, though it needs to resist any temptation to protect its core banking sector if it wants to stay top, the Forum added.
The Geneva-based body, most famous for gathering politicians and billionaires at an annual shindig in the Alpine resort of Davos, revealed that the same economies made the top 10 as last year, but in a different order.
Germany, the United States, Hong Kong and Japan all edged up while Sweden, the Netherlands and the United Kingdom all slipped by two or three notches.
The United States’ flair for innovation helped it reverse a four-year downward trend, although serious concerns remained over its macroeconomic stability, the Forum said, ranking it 117 out of 148 countries in that category.
The Forum bases its assessment on a dozen drivers of competitiveness, including institutions, infrastructure, health and education, market size and the macroeconomic environment.
The report also factors in a survey among business leaders, assessing the government’s efficiency and transparency.
Switzerland scored well across the board, but the report said it needed to guard against complacency.
“Its banking sector is … Under scrutiny, and this traditional economic engine is necessarily undergoing great change,” the report said.
“In the future, it will be important for the country to continue to build on its competitive strengths and resist over regulation and protectionism,” it added.
Switzerland has been hit hard by a global crackdown on tax havens, succumbing to pressure from the EU and the United States to give up a centuries-old tradition of banking secrecy.
While most of the top 40 remained relatively static, South Korea slid six places to 25th, weakened by its poorly functioning financial market, quality of its institutions and extremely rigid labor market, said the report.
China remained in 29th place and again led the BRICS pack, while Indonesia climbed 12 places to 38th, helped by a 17-place jump in infrastructure and other advances.
“After years of neglect, Indonesia has been boosting infrastructure spending to upgrade roads, ports, water facilities, and power plants, and our results suggest that these improvements have started to bear fruit,” the report said.
It also made a big improvement in labor market efficiency, but was let down by bribery, security and a worsening health picture.
India slipped one position to 60th while Russia edged up three spots to 64th, helped by an improving macroeconomic environment.
There was also little change at the bottom of the list. The overall wooden spoon went to Chad, just behind Guinea and last year’s loser Burundi.
The report defines competitiveness as “the set of institutions, policies, and factors that determine the level of productivity of a country”. REUTERS