Macroeconomic and monetary policy: the basics

There are two main areas in economics: micro- and macroeconomics. Microeconomics is the study of individuals and individual firms, analysing how they react to changes in the wider economy. Macroeconomics on the other hand is the study of this wider economy, principally examining changes in the areas of unemployment, national income, GDP, inflation, as well as price levels. These two methods of studying economies are often inter-related in that factors affecting the economy as a whole (macro-), such as a rise in unemployment, will also affect individuals (micro-) e.g. the supply of workers available to individual firms.

Macroeconomic policy is simply a policy to maintain a stabilised economy. This is achieved largely through the manipulation of two main tools; monetary and fiscal policy. Both of these ‘sub-policies’ are used simultaneously to try and achieve the desired level of GDP (which is usually at a level representative of full employment).


A brief introduction to monetary and fiscal policy by Paddy Hirsch.

NOTE: this demonstration is based on the American economy.

UK equivalents: Federal Reserve = Bank of England, Congress = Government


Monetary Policy

Monetary policy can be described as the induced changes by a central bank in either the rate of interest, money supply or the exchange rate, to maintain a stable economy. In the UK, the Bank of England focuses (primarily) on interest rates – importantly the Bank’s target inflation rate of 2%. Monetary policy has been the dominant form of macroeconomics for the past 30+ years. The Bank of England uses policy interest rates to regulate the economy and meet their macro-objectives;

  • price stability
  • sustainable growth of real GDP
  • falling unemployment
  • higher average living standards
  • improved global competitiveness
  • a more equitable distribution of income and wealth

Changes to Interest Rates

The Bank of England can influence consumer spending in the economy by changing the rate of interest it pays on reserves held by commercial banks (Bank Rate). For example, by reducing interest rates, saving becomes less attractive whilst borrowing seems more attractive. This increases consumer’s disposable income, which in turn stimulates spending. Higher interest rates have the opposite effect to this.

These changes in interest rates can also have an affect on consumers’ and firms’ cash flows i.e. lower interest rates reduce the income earned on savings, but also reduce the interest payments due on loans (provided these are not fixed rate loans).

Changes to Exchange Rates

With respect to the exchange rate, an increase in interest rate will make UK assets more attractive to foreign investors and thus will increase the value of sterling. This will reduce the price of imports and increase the price of UK exports, reducing the demand for UK goods and services abroad. It is therefore evident from this that it is of vital importance that interest rates are constantly and carefully monitored to ensure a positive balance between investor income and UK export trading.

Changes to Money Supply

As explained above, normal monetary policy follows the procedure of increasing or decreasing interest rates. But what happens when interest rates are lowered to 0.00% and the economy still isn’t growing? Since the banks can no longer cut interest rates, some other, more unconventional policy must be adopted. In March 2009, this very situation occurred in the UK, and for the first time, the Bank of England adopted a policy of quantitative easing.

“Quantitative easing (QE) is an unconventional form of monetary policy where a Central Bank creates new money electronically to buy financial assets, like government bonds.” Bank of England

Quantitative easing aims to increase the supply of money in the banking system and to stimulate the economy when conventional monetary policy has been ineffective.

For more information about Monetary Policy click here.

Fiscal Policy

Fiscal policy involves the government changing the levels of taxation and government spending as a means of influencing aggregate demand (AD) and the level of economic activity (based on Keynesian economics). Aggregate demand is the total level of planned expenditure in an economy and is expressed as;

AD = C + I + G + (X – M)

C – consumer spending, I – investments made by government, G – government spending, X – demand from exports, M – demand from imports

Fiscal policy aims to stabilise economic growth, avoiding a ‘boom (expansionary) – bust (deflationary)’ economic cycle. It is often used in conjunction with monetary policy (which is generally preferred). The main problem with placing any significant importance on fiscal policy is the fact that this policy will change depending on which political party gets into power. These parties will have varying and often very differing policies, for example, tax cuts and increases to different classes.


Example (taken from Investopedia)

Let’s say that an economy has slowed down. Unemployment levels are up, consumer spending is down and businesses are not making substantial profits. A government thus decides to fuel the economy’s engine by decreasing taxation, which gives consumers more spending money, while increasing government spending in the form of buying services from the market (such as building roads or schools). By paying for such services, the government creates jobs and wages that are in turn pumped into the economy. Pumping money into the economy by decreasing taxation and increasing government spending is also known as “pump priming.” In the meantime, overall unemployment levels will fall.

With more money in the economy and fewer taxes to pay, consumer demand for goods and services increases. This, in turn, rekindles businesses and turns the cycle around from stagnant to active.

If, however, there are no reins on this process, the increase in economic productivity can cross over a very fine line and lead to too much money in the market. This excess in supply decreases the value of money while pushing up prices (because of the increase in demand for consumer products). Hence, inflation exceeds the reasonable level.


Click here to read an article on ‘Fiscal Policy’ by Prof. David Weil (Brown University)

 

References

Hirsch, P. (2011). Fiscal and Monetary Policy. [online] YouTube. Available at: http://www.youtube.com/watch?v=TvzsjOmWgKI [Accessed 1 Jul. 2015].

Heakal, R. (2004). What Is Fiscal Policy?. [online] Investopedia. Available at: http://www.investopedia.com/articles/04/051904.asp [Accessed 1 Jul. 2015].

tutor2u, (n.d.). Monetary policy. [online] Available at: http://beta.tutor2u.net/economics/topics/monetary-policy/reference [Accessed 1 Jul. 2015].

Weil, D. (n.d.). Fiscal Policy: The Concise Encyclopedia of Economics. [online] Econlib.org. Available at: http://econlib.org/library/Enc/FiscalPolicy.html [Accessed 1 Jul. 2015].

Featured image courtesy of http://cdn.pieria.co.uk/new_live/dr/section_main/254.jpg

 

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