Inflation Control by Government of UK Economy - Essay Example

Inflation Control by Government of UK Economy Introduction The UK economy is about three-quarters the size of Germany's and vies with France for the position of fourth largest economy in the world. Almost 70% of GDP in the UK is accounted for by private consumption. Government consumption has been contained in recent years by strict controls on public spending, but is set rise again over the next few years as the government strives to improve deficient public services. The share of GDP accounted for by gross fixed investment varies according to the UK's position in the cycle, but typically fluctuates in a range of 16–17% of GDP. Low levels of investment are often cited as factors behind the UK's poor productivity performance. The rate of overall fixed capital formation in the UK is depressed by the very low level of public investment. During the 1970s and much of the 1980s the UK endured persistently high inflation. Despite high levels of unemployment, wage increases in the 1980s exceeded productivity growth, provoking strong upward pressure on prices. The boom of the late 1980s created a new inflationary surge, painfully controlled only by high interest rates and the early 1990s recession. Since then, however, the UK's inflation performance has improved markedly. The government has preferred measure of inflation, the RPIX (which excludes mortgage interest payments), has fluctuated within a narrow range in recent years and even came in below the official central target of 2.5% in 1999–2001. Meanwhile, inflation as measured by the EU's harmonised index averaged just 1.2% over 2001, the lowest rate in the EU. Two aspects of the UK's recent inflation performance are worth recording, however. The first is that there has been a significant divergence since mid-1998 between goods and service sector inflation, with the latter accounting for most of the increase in the consumer price index. In fact, in many parts of the goods sector (notably clothing, footwear and audio-visual equipment); prices actually fell in 2000 and 2001. A second aspect worth noting is the sharp (and probably unsustainable) appreciation of sterling's trade-weighted exchange rate since 1996, which has exerted considerable downward pressure on import prices. This paper discusses the inflation control methodologies in United Kingdom from 1994 to 2004. It shall also discuss how UK has managed its inflation in the last few decades. The paper shall also provide recommendations for inflation control by effective governance. Historical Monetary and Fiscal policies of UK Monetary policy The UK has experimented with numerous frameworks for monetary policy over the past 15 years. In the 1980s, the Conservative government tried in vain to target various measures of the money supply, before deciding to target the exchange rate. After “tracking” the D-mark in the late 1980s, the UK joined the EU's exchange-rate mechanism (ERM) in October 1990, only to be ejected two years later, in September 1992, when speculative pressures forced sterling out of the ERM. Following its exit, the UK was one of the first OECD countries to adopt inflation control. An inflation target range of 1–4% was initially set, but responsibility for setting interest rates remained with the government. When the Labour government came to power in 1997, its first significant decision was to grant operational independence for setting interest rates to a newly constituted Monetary Policy Committee (MPC) within the Bank of England. The responsibility for setting the annual inflation target, however, remains with the government. Under the current target, the MPC must aim to keep RPIX inflation—a measure, which excludes mortgage interest payments—within 1 percentage point either side of a central target of 2.5%. Inflationary expectations have fallen sharply since the MPC assumed responsibility for monetary policy, and long-term interest rates have dropped to their lowest level in over 30 years. The MPC has periodically come under fire for paying excessive attention to the service-sector boom in the south of the country and for ignoring the plight of the manufacturing sector in the midlands and the north, but it is generally recognised to have performed well, and the policy framework is often held up as a model of transparency and accountability in international comparisons. Fiscal policy The Labour government has complemented its overhaul of the monetary policy framework with a new, medium-term framework for fiscal policy. The framework builds partly on the medium-term financial strategy (MTFS) inherited from the previous government, which defined the objective of fiscal policy as balancing the budget over the medium term. The first plank was laid in the Labour government's first budget in July 1997, when the chancellor of the exchequer, Gordon Brown, announced two rules which fiscal policy would aim to respect: first, that over the course of an economic cycle the government would only borrow to invest, not to fund current spending (the “golden rule”); and second, that over the course of an economic cycle the ratio of public debt to GDP would be held at a “stable and prudent” level. The two rules were complemented in Mr Brown's second budget in March 1998 by a “code for fiscal stability”, which the chancellor placed on a statutory footing. The code's purpose is to improve the credibility, transparency and accountability of fiscal policy by setting out explicit provisions against which the government's record can be judged. The framework was completed with the publication of two further documents in June and July 1998: the Economic and Financial Strategy Report (EFSR) and the Comprehensive Spending Review (CSR). The EFSR abolished the traditional annual spending round in favour of a three-year framework for public spending (even if some categories of spending, such as social security, remain subject to annual reviews at the time of the budget). The motivation for moving to a three-year framework is to increase the Treasury's control over public spending by reducing the influence of annual bidding rounds on budgets. The new regime requires ministries to sign public service contracts with the Treasury, which lay down detailed targets in the areas for which they are responsible, and the resources which they propose to allocate to them. However, successive budgets have shown that the public spending limits set out in the three-year spending framework can be breached when the government finds it politically expedient. This was the case, for example, in the 2001/02 budget, when the Chancellor of the Exchequer announced increases over and above those in the three-year CSR to 2003/04 (which he had set out in July 2000). Departmental spending for the three-year period is set out in the CSR, which is carried out every three years. The first CSR, covering the three-year period to 2000/01, was constrained by an electoral commitment to adhere to the two-year public spending limits put in place by the previous government. The result was that at the end of the 1999/2000 financial year public expenditure's share of GDP had fallen below 38%, its lowest level since the mid-1960s. The second CSR, the details of which were announced in July 2000, faced no such constraints. It provided for an extra £43bn (US$65bn) in public spending up to the financial year ending April 2004, with particularly large increases reserved for the under-funded health, education and transport sectors. However, the increases between 2001 and 2004 will only reverse the effects of the tight rein on public spending between 1997 and 1999. Historical UK Inflation rate (Source: http://www.statistics.gov.uk/cci/nugget.asp?id=19 accessed on 5th March 2008) Strategies of Inflation control In recent years, “inflation targeting” is one of the major macroeconomic policy instruments in United Kingdom. Under this regime, it has been argued that “Phillips Hypothesis” is no longer appropriate to achieve a trade-off between inflation and unemployment. Investigate this argument with the United Kingdom inflation and unemployment data in between 1994 to 2004. Inflation and Unemployment (Phillips Curve) The Phillips curve, named after A.W. Phillips, shows how inflation and unemployment are said to be inversely related. His hypothesis is primarily based on his observation with regard to the prevailing economic conditions in Great Britain from the onset of the 1900s until 1958. According to his published article, Phillips posited that when unemployment rate fell, inflation tended to rise and vice-versa, thus, the apparent link between these economic factors. (Cobham, 1998) However, with the recent economic trends, economists of various countries noted that low inflation can, in fact, coexist with low unemployment rate (Oliver, 1999). Such observed trend is deemed to be contrary to the hypothesis of Phillips. Inflation-Unemployment Relation – The Case of United Kingdom The theories discussed only addressed scenarios in which stagflation occurs and when inflation and unemployment behave inversely. In the case of United Kingdom and in other OECD countries as well, particularly in the 1990s to early 2000s, the robust output growth and prevailing low unemployment rate are coupled with low inflation. The growing United Kingdom economy even requires additional labour but manages to pose no substantial acceleration in inflation. (Argy, 2005) According to the report of the United Kingdom Bureau of Statistics (2004), though inflationary pressures persisted in the 1980’s, partly attributed to oil price shock, it began to slow down in the early 1990s and has remained at relatively low levels in 2000s. In the aspect of labour, the unemployment rate declined steadily to about 8% from 1995 to 1997. From then on, it has been falling gradually. In case of UK, it is apparent that decreasing unemployment is accompanied by declining inflation, specifically from 2001 to 2004. Some economists believe that such trend in the inflation-unemployment trade off, which runs contrary to the “Phillips Hypothesis,” is brought about by the deregulation of financial markets and freezing up of external trade in 1980’s. In this regard, excess aggregate demand is said to more likely affect current account deficit rather than inflation. As such, the link between inflation and unemployment is not as striking as it used to be. (Argy, 2005) Source: tradingeconomics.com Nevertheless, the government can control inflation as economic improvement is a ramification of optimistic policy developments such as United Kingdom’s monetary stance (Argy, 2005) and the introduction of structural labour market reforms in the 1990s (“United Kingdom Chamber of Commerce,” n.d.). Monetarists deem inflation as mainly a monetary phenomenon, which occurs when the central bank allows the money supply to grow too fast (Bowden & Carlin, 1977). This has emphasized the vital role of a country’s central bank in controlling inflation. In terms of the monetary policies implemented by the Bank of England (BOE), the framework introduced allows for the expression of inflation target as a range, thus, allowing flexibility. Furthermore, the inflation target, which does not take into account extraordinary factors like one-time increase in oil and other commodity prices, is expressed as an average over a certain period. In this regard, the monetary framework utilised by the BOE provides an anchor for inflationary expectations of industry players. Moreover, such model enables financial institutions to react based on medium-term prospects (Argy, 2005). These factors accompanied by either contractionary or expansionary monetary policies to control the growth of money supply have facilitated the maintaining of inflation at stable levels. To address unemployment, the government has introduced economic and regulatory reforms, specifically in the labour market (“United Kingdom Chamber of Commerce,” n.d.). The government has undertaken significant reforms to employment service such that the efficiency of job search and matching is substantially enhanced. It has also invested considerably on post school education, training and re-skilling so that the local labour force matches industry skill requirements. (Argy, 2005) Furthermore, the government’s highly interventionist approach has significantly reduced trade-union bargaining power and increased competition in the product market. Relating this to inflation, potential cost-push pressure in price increases is eased and greater movements of relative wages are permitted. These factors have also inculcated better wage and price disciplines among employers. (Argy, 2005) Conclusion Given the United Kingdom case, it can be concluded that a well-managed policy mix is crucial to attain sustainable growth with moderate inflation. Monetary policies and fiscal reforms play an important role in honing the economy based on indicated targets. As mentioned, this economic condition renders the so-called “Phillips Hypothesis” inapplicable since there is no perceived trade-off between the said factors as previously believed. In this case, United Kingdom’s monetary perspective and economic regulations have positively affected its output growth as well as uphold low levels of unemployment and inflation. As part of the incomes policies to control these economic factors, the United Kingdom government has implemented market strategies, which strengthen market forces and impose discipline on price and wage levels. The low unemployment and stable inflation regime bode well for both investors and workers since they are better equipped to make wiser consumption, saving and investment decisions. References Argy, F. (2005). An Analysis of Joblessness in United Kingdom. Economics Society of United Kingdom, March 2005. Bank of England. (2005) Retrieved March 4, 2008 from: http://www.rba.gov.au Bowden, E.V. & Carlin, T.W. (1977). Economics. Alexander Hamilton Institute. British Chambers of Commerce. Structural Labour Market Reforms: The Key to Sustaining Lower Unemployment. Cobham, D. (1998). Macroeconomic Analysis. Pearson Education Oliver, C. (1999). Who is Afraid of a Red-Hot Economy?-Investor’s Business Daily. Ludvig von Mises Institute. Retrieved March 4, 2008 from: http://www.mises.org/story/149 Trading Economies; UK Inflation; http://www.tradingeconomics.com/Economics/Inflation-CPI.aspx?Symbol=GBP accessed on 5th March 2008 United Kingdom - National Statistics; (2007) from www.statistics.gov.uk accessed on March 4, 2008 Read More