Housing and Monetary Transmission Mechanism - Term Paper Example

The Macroeconomics of UK since 2008 2009 The Circular Flow of the Real Economy In an economy, money flows between economic agents - households, firms and the government - through various markets - the market for goods and services, markets for factors of production and the financial markets. Households receive income and use it to pay taxes to the government, consume goods and services, and to save through the financial markets. Firms receive revenues from sale of goods and services and use it to pay for factors of production. The government receives revenue from taxes and uses it to pay for government purchases. Any excess tax revenue over government spending is called public saving, which can either be a budget surplus or a budget deficit (Mankiw, 2008). Aggregate demand is the economy-wide demand for goods and services by all economic agents and aggregate supply is the total goods and services produced. The macroeconomic model of aggregate demand and aggregate supply determines the relationship between aggregate price level and aggregate output in the short run as well as the long run through the interaction of all the markets (Mankiw, 2008). The aggregate demand curve, that is the relationship between AD and aggregate price level, is drawn for a given supply of money. It slopes downward since higher the price level, lower is the real money balances, on account of the Quantity Theory of Money, and so lower is the demand for goods and services. The aggregate supply curve is the relationship between total goods and services produced in the economy and the price level. The long run AS supply curve is vertical while, in the Keynesian macroeconomic model, the short run AS curve is horizontal since prices are assumed to be sticky in the short run. In the long run, changes in aggregate demand affect prices but in the short run, changes in aggregate demand affects output only. Keynes proposed that low aggregate demand is responsible for low income and high unemployment that characterize economic downturns. This is in contrast to the classical view that aggregate supply, depending on the supply of labor capital and technology, determines national income. To reconcile these two views, it is considered that in the long run, prices are flexible so that aggregate supply determines the national income while in the short run, prices are sticky so that aggregate demand determines national income (Mankiw, 2008). The IS-LM model of aggregate demand represents the interaction of the goods and money markets. The IS curve is a downward sloping relationship between rate of interest and output that is derived from the equilibrium in the goods market. Here, planned expenditure, given by the total of consumption, investment and government expenditure in the closed economy and in addition, net exports in the open economy, is equal to the actual expenditure, given by the total output. Consumption depends on the disposable income after paying taxes, investment on interest rates, through the loanable funds market, and exogenously given government expenditure and net exports. In the money market, the LM curve denotes the relationship between rate of interest and output such that real money supply is equal to the real money demand. Even though money supply and prices are exogenous in the short run, real money demand depends positively on output (through the quantity theory of money) and rate of interest (through the theory of liquidity preference). The intersection of the IS and LM curve gives the equilibrium rate of interest and output. Thus, the interaction of the money market, the goods market and the loanable funds market determines equilibrium output and rate of interest. This may or may not be equal to the full employment output which is achieved in the long run when prices are flexible (Mankiw, 2008). Role of Government Policies If the economy is producing less than full employment output at equilibrium, the government can increase output by either fiscal policy or monetary policy. Fiscal policies to boost output include additions in government purchases that add to the aggregate demand or reduction in tax rates so that disposable income is increased and consumption is boosted. An increase in government expenditure leads to a greater increase in output, depending on the government expenditure multiplier, which in turn depends on the marginal propensity to consume. The government expenditure multiplier is given by 1/(1-MPC) where MPC is the marginal propensity to consume. Reduction in taxes also increases output by a greater amount, through the multiplier effect, -MPC/(1-MPC). But, the tax multiplier is smaller in absolute value than the government expenditure multiplier. The fiscal policy, either government expenditure increase or tax reduction, shifts the IS curve to the right as for every level of rate of interest, output is greater because of the addition in government purchases and hence aggregate demand. However, this raises the interest rate since the equilibrium in the goods market and money market occurs at a higher output and also higher real interest rates. However, with higher interest rates, part of the multiplier effect is offset by the reduction in investment (Mankiw, 2008). Monetary policy involves an increase in money supply. Holding the income and therefore the demand for real money balances constant, this lowers the rate of interest. Hence, LM curve shifts to the right as a result of money supply increase. Lower interest rates boost investment in the goods market and increases output (Mankiw, 2008). The fiscal policy and the monetary policy can be initiated simultaneously depending upon the target variable. A tax cut or increase in government expenditure shifts the IS curve upward. If the central bank holds the money supply, this will raise interest rates and also increase output but less than the multiplier effect. However, if the central bank also increases money supply so that interest rate is held constant, output would be greater. On the other hand, if the central bank reduces money supply to hold output, rate of interest would rise by a larger amount than that induced by only the fiscal policy (Mankiw, 2008). The UK economy since 2008 Through the 2000s till 2007, interest rates in the United Kingdom were relatively low, which resulted in high economic growth through increase in aggregate demand. In particular, house mortgages boomed because of low interest rates. With the availability of collaterals and liberalization of the credit markets, the housing market has a 'wealth effect' through the stock market. For about a decade, availability of housing credit and spiraling of house prices, a large number of families accumulated significant wealth (Muellbaur, 2007). The housing market affects monetary policies, hence interest rates, through direct effects on the user cost of capital, expectations of future movements of housing prices and the supply of housing as well as indirectly through effects on the real economy. The latter influence works through wealth effects of housing prices, credit effects of consumer spending and the subsequent effects on housing demand. The housing sector has the potential to result in overall financial instability both in the real and monetary economies and eventually lead to a situation in which the central banks are unable to stabilize the situation (Mishkin, 2007). Housing wealth has also been accompanied with non-housing wealth through the stock markets. The UK had been a recipient of large amounts of financial investment inflows which increased the speculation in the stock markets and the wealth effects on the households through the stock markets. However, consumption spending reacts to housing wealth more than it does to non-housing wealth, as has been found by various studies (Mushkin, 2007). As a result of the housing and construction boom, the UK economy continued to grow despite a weak physical investment scenario. The subprime crisis that began in the US in 2007 spread across the world including the UK. Since 2008, the economy has been in a recession. As a reaction to the downturn, the government offered a fiscal stimulus package and expansionary monetary policy to induce growth. However, a weak fiscal position of the government has meant that the stimulus package was not as much as was needed. Till October 2009, the UK economy was still in recession even as other European economies like Germany and France was gradually emerging out of the crisis. By then the UK economy had witnessed a decline in GDP for the sixth consecutive quarter. The British government had initiated fiscal stimulus packages like most economies to tackle the recession but the government budget is under strain so it is likely that there might have to be some cuts in spending (Faiola, 2009). As a result of the recession, consumer spending has been cut severely. While the savings rate is rising, which bodes well for the economy in the long run, it limits the growth possibilities in the short run (Faiola, 2009). The economy is also facing a tight credit situation making it harder for companies to grow (MacDonald, 2009). There has been a shift of the economy away from the manufacturing sector towards the services, mainly financial services as a result of the booming housing market and the inflow of foreign capital. This is also the reason why the UK economy is taking longer than other European countries to emerge out of the recession. Despite the fiscal and monetary policies that are aimed at increasing aggregate demand and money supply respectively, it has failed to boost output to a large extent because of the sluggishness of investments to react to the higher savings rate. Because of the excessive dependence on borrowings, the economy has become debt-ridden (Postrecession, 2009). Works Cited Mishkin, Frederic S (2007). "Housing and Monetary Transmission Mechanism". August. Board of Governors of the Federal Reserve System Muhlesein, Martin and Christopher Towe (2004). "US Fiscal Policies and Priorities for Long run Sustainability", International Monetary Fund, January 7. Available on http://www.imf.org/external/Pubs/NFT/Op/227/#overview. MacDonald, Alistair, U.K. Economy Continues to Shrink, Wall Street Journal, 24 October, 2009, http://online.wsj.com/article/SB125628626596003463.html Faiola, Anthony, U.K. economy sinks deeper into recession, October 23, 2009, http://www.washingtonpost.com/wp-dyn/content/article/2009/10/23/AR2009102300774.html Post recession, UK Economy after the recession, January 2009, http://postrecession.files.wordpress.com/2009/01/whitepaper6.pdf Read More