Macro-Economic Tools Used to Avoid Deflation and Its Side-effect on the Economy - Assignment Example

Macro Economics Table of Contents Table of Contents 2 Question 3 Introduction 3 Why Euro Zone Concerned about Deflation 4 Macro-economic Tools Used to Avoid Deflation and its Side-effect on the Economy 6 Interest Rate Policy 7 Minimum Liquidity Asset Ratio 7 Open Market Operations 8 Selective Credit Control 8 Conclusion 10 Question 2: 11 Introduction 11 Discussion 11 Gross Domestic Product (GDP) 12 Inflation Rate 14 Exchange Rate 16 Unemployment Rate 18 Conclusion 19 References 21 Question 1: Introduction Over the years the Euro zone has remained much conscious about the high inflation rate in several European countries such as such as Spain, Portugal and Ireland among others. In this regard, Euro Zone has taken certain economic measures with the intention of reducing the effect of recent financial crisis as well as recession related problems. Notably, during the recovery phase, the Euro zone has witnessed certain challenges in terms of inflation, which has weakened the economic condition of the zone. In order to control the rapid rise in the inflation rate Euro zone has undertaken certain measures which has eventually imposed the threat of deflation in the zone. In this regard, it can be argued that deflation signifies the rapid decline in the overall level of prices of the goods and services. More specifically, it can be claimed that deflation usually does not belong only fall of prices of the goods and or services, rather it create a negative impact on the Consumer Price Index (CPI), which can causes steady economic decline for a longer period of time1. In this particular study, the objective is to identify the reasons, why Euro zone is currently concerned about the deflation situation rather than inflation. At the same time, the study will also try to identify the macro-economic tools, which are available to avoid deflation situation in the economy of Euro zone. Moreover, this particular assignment attempts to identify the consequences or the possible side effects of deflation in an economy. Why Euro Zone Concerned about Deflation In the contemporary era, it is revealed that several developed countries have witnessed deflation situation in the economy, in the course of achieving below target inflation. In this regard, it can be claimed that deflation usually arises in the economy not only for the reasons of theoretical problem; rather it can be argued that deflation is caused in an economy because of the problems of economic policy. Since the phenomenon of globalization has observed in the global economy, it is identified that Euro zone has faced recession for several times. According to the viewpoint of Bartholomew (2014), European Central Bank (ECB) has tried to increase the inflation around 2% in its economy. In this regard, it is revealed that ECB has pressurized its loosening of monetary policy through reducing the interest rate. At the same time, ECB has also reduced its exchange rate in Euro zone. As an effect of this consequence, it is identified that the overall prices level of the goods has been declined in the Euro zone. On the other hand, it is also notified that price stability has become inconsistent in the Euro zone2. According to the report of Oxford Economics (2014), it is identified that deflation signifies a negative economic situation for an economy. In this regard, it can be argued that deflation situation usually lead reduction of the general prices level of the goods and services. It is also perceived that deflation usually pushed the cost of the asset towards downwards. As an effect, it can be revealed that deflation initiate immense challenges on the economy of a particular nation3. Elwell (2010) argued that there is huge difference in between the effect of deflation and temporary price decrease of the goods and services. Regarding this aspect, more especially it can be argued that the effect of deflation can affect the fall of prices of the goods and services in a continuous manner. In this case, an economy usually takes certain period of time for creating an inflation situation again and it also hampers the liquidity stability of a nation. Whereas on the other hand, temporary price fall does not hamper the liquidity stability of the nation, rather the situation reverses within quick span of time4. In order to identify the negative consequences of deflation and its impact on the economy, it is revealed that deflation situation has helped in case of enhancing the production efficiency of a country. Rationally it can be claimed that due to the effect of deflation situation overall price of commodities have been reduced, which usually lead towards enhancing the profit margin of the produced item. At the same time, it can be argued that due to the deflation situation on the economy, consumers have to pay low price while buying any goods and or services, which enhances the purchasing power of the consumers, but it also adversely affect the circulation of the money. Thus, it can be claimed that this kind of economic situations usually hamper the economic condition and flow of money flow for a nation and further it also lead to certain challenges in the future5. According to the report of EY Euro Zone Forecast (2014), it is revealed that with the intention of reducing the inflation rate, the Euro zone has adopted certain economic measures with the assistance of the International Monetary Fund (IMF). As an effect, it is revealed that the aim of reducing inflation has imposed radical threat of deflation in the Euro zone. The impacts of deflation may cause serious challenge for the business and commercial activities. As an effect of deflation, it can be stated that in case of an economy the price of the goods and assets remains unchanged for the longer period of time, which can caused decline in the overall valuation of the income and property of the nation. This consequence will not motivate foreign investors to investment on that particular nation, which will reduce the overall opportunity for that economy and further leading towards the emergence of deflation threat for longer period of time. In this regard, the report of EY Euro Zone Forecast (2014) described that the impact of deflation can also create a negative impact on sustaining competitiveness of an economy and it may also hamper the cross border agreements or cooperation related to the trade and commercial aspects. As an effect, the impact can be directly observed on the import and export related activities of a nation, which may hamper the growing opportunity of emerging market. On the other hand, it may also infuse exchange rate related risks for an economy. Thus, based on the above observation, it can be argued that Euro zone has remained conscious about deflation in the economy6. Macro-economic Tools Used to Avoid Deflation and its Side-effect on the Economy According to the report of EY Euro Zone Forecast (2014), it is revealed that the Euro zone has applied monetary policy instrument with the assistance of IMF driven with the intention of reducing the deflation situation in the economy7. In this regard, it can be claimed that Euro zone has taken certain measures those are illustrated and discussed below: Interest Rate Policy In this regard, it can be claimed that the ECB has increased the interest rates for the borrowing principles with the intention of discouraging the borrowing of the citizens. In this context, European bank and financial institutes have identified that this interest rate policy is one of the most suitable measures through which it can be possible to secure the funds for the Euro zone more apparently. Thus, it can be claimed that through emphasizing towards the interest rate policy Euro zone has able to reduce the impact of inflation on the economy. On the other hand, through enhancing the rate of the interest, Euro zone has kept sustainability on the economy and reduced the chances of deflation8. Minimum Liquidity Asset Ratio Similarly, in order to ensure the control on the economic situation, Euro zone has taken into consideration certain monetary instruments such as liquid assets and cash. In this regard, it is also identified that the ECB usually consider the proportion of total assets as a one of the most effective instrument through which it can be possible to ensure the control over the monetary policy, which can reduce indiscrimination in the economy. In this regard, the actual objective of the ECB was to ensure a control over the free cash base and ECB has also tried to reduce the flow in the market with the aim of reducing the chances of inflation. Thus, it can be claimed that through the assistance of IMF, ECB has reduced the excess money supply in the economy to avoid of deflation situations in the Euro zone9. Open Market Operations Simultaneously, it can be argued that the ECB has applied open market operation measures with the aim of ensuring the control over the sale as well as purchases of securities. In this regard, it can be claimed that through utilizing this measures the ECB has targeted to ensure the availability of cash balance in the commercial banks as well as other non banking institutions, which has helped to ensure the availability of reserve money. Thus, it can be claimed that through the incorporation of this measure, the ECB has tried to ensure its flow of supply of the reserve in the Euro zone, which has also reduced the chances of deflation situation in the Euro zone10. Selective Credit Control Moreover, it is also revealed that through incorporating quantitative measures reading the credit control aspects, the ECB has encouraged few essential sectors of the economy for preventing the chances of deflation. In this regard, it is identified that the governing bodies of European Union have tried to restrict government borrowing up to an extent for ensuring the reduction of excess government expenditure. Moreover, it can be argued that through incorporating this measure, the ECB has reduced the chances of crisis and deflation in the economy11.Based on the above discussion, it is revealed that the ECB has taken various monetary policies measures with the aim of overcoming the extreme inflation rate in the economy, which usually ensures unfavourable balance of payment in the economy. At the same time, it can be argued that high volume of debt and budget deficit can be reduced by incorporating these monetary policies measures12. Through the incorporation of above stated measurers it can be claimed that extreme inflation rates has increased the challenges of the overall economic situation of the Euro zone. Simultaneously, it can be also argued that several countries of Euro zone have faced extreme inflation rates and accordingly applying this extreme inflation rates several countries have reduced its debts as well as budget related deficits. On the other hand, most of the countries have ensured their unfavourable balance of payment situations. In this regard, in order to identify the side effects of the monetary policies measures, it can be claimed that instead of adoption of monetary policies measures several European countries have remained poor the unfavourable economic situations, which has also influenced political turmoil in the economy and has led the economy of the Euro zone towards unsteadiness. Simultaneously, it can be also argued that as an effect of these monetary policies measures depression and recession situations have erupted in the economy, which has hampered the stability of the economy13. Conclusion Based on the above discussion, it is revealed that over the last few years Euro Zone has faced several challenges in its micro-economic environment due to the high rate of inflation in the economy. In this regard, it is identified that European countries have faced several challenges due to the flow of money supply in the economy. At the same time, it can be argued that soaring cost of the goods and services have also affected the flow of money supply in the economy. In this context, the ECB has taken certain measures with the assistance of the IMF for ensuring the money flow in the economy. Accordingly, the ECB has applied monetary policy measures with the aim of fulfilling the objectives of macro-economic situations. Based on the above discussed evidences, it can be argued that the Euro zone has revealed concerned about deflation situation on the economy during incorporating measures with the aim of reducing the target inflation. Moreover, it is also identified that monetary policies measures have raised depression and recession situations in the economy of Euro zone. Simultaneously, it has also hampered the growth of the economy. It is thus crucial for the Euro zone, to devise strategies that would assist to reduce the increasing inflation rate while at the same time it should not lead the zone to the problem of deflation. Question 2: Introduction Macroeconomic analysis specifically includes evaluation of those factors that are responsible for stabilizing the economical balance of a nation. As a matter of fact, they find prime applicability within the areas of trade, commerce and foreign business establishment. The provided context also illustrates the significance of four key microeconomic factors namely inflation rate, gross domestic product, exchange rate and unemployment rate14. From a technical perspective, these four variables can be categorised as the major factors that supports the continued growth process of a nation’s economy through appropriate revenue generation. Considering these aspects, the discussion will majorly focus towards evaluating the possible steps through which the UK government has been making efforts towards influencing these macroeconomic factors in alignment with its perceived objectives. Specific sections of the discussion also includes explanations regarding how these four chosen macroeconomic variables impact the economic stability of the UK in the present competitive scenario. Discussion The countries across the world, particularly the European countries were seen to be the most adversely influenced by the financial crisis and the economic recession. The recovery path for these countries is also perceived to be a challenging task for the respective government. Nevertheless, the like several other countries The UK is also faced with numerous challenges which is mainly attributed to the consequences of financial crisis and economic recession witnessed by the world in the recent years. Thus, the systematic explorations and interpretations of the four chosen macroeconomic variables have been provided in a detailed hereunder. Gross Domestic Product (GDP) GDP has always been a major macro-economic indicator of a nation’s economic growth. Thus, a higher rate of GDP growth eventually attracts multiple counts of international business processes in context to making higher percentage of investments and establishment of their business processes within the GDP rich nations. The UK in the present scenario is seen to make deliberate effort towards the attainment of an appreciable GDP rate after being subjected to the economic turmoil of 2009. Evidence regarding this has been illustrated below through graphical representation of the attained GDP rate between the periods of 2012 to 2014 Source 15 The UK government has always been reliant upon the implementation of specific policies as a tool for influencing its GDP growth. For instance, the government tended towards increasing the leniency associated with taxation and establishment procedures of small and medium scale enterprises after being adversely struck by economic recession during the 2008-2009. Moreover, the growing economy of this superpower also relies upon other major service sectors such as petroleum, finance, aerospace, automobiles and pharmaceuticals among others16. Implementation of taxations within the major service sectors has also been categorised as another credential tool that has supported the government’s objective of attaining higher levels of economic stability. The UK has also shown higher degree of resilience towards collecting revenue from all its service sectors in the form of tax and licensing. As a matter of fact, the external investors find it highly difficult to establish their business processes within the domestic markets of the UK due to the higher restrain levels established by the UK government17. Moreover, due to the increasing level of government spending within the domestic economy, the UK government has also taken initiative towards securing additional funds in the form of borrowing from the global banks with the prime intention of maintaining its current pace of GDP growth18. Inflation Rate Likewise, inflation rate can also be categorised as a strong determinant ensuring the flow of funds within the economy. In this context, the UK government aims at projecting higher levels of rigidity within its monetary and fiscal policies that are specifically structured for generating appreciable percentage of revenue from the service sector. However, the inflation rate within a nation specifically depends upon two specific criteria namely ‘consumer price index (CPI)’ and ‘retail price index (RPI)’. Interestingly, through higher levels of government spending and subsidy provisions, the UK government has succeeded in minimizing both its CPI and RPI to a certain level and has been substantially able to control the rapidly increasing inflation rate. Evidence regarding this has been provided below graphically19 Source 20 In addition, the UK government has also focused towards influencing the per capita income factor within its domestic economy through the provision of its subsidiary services with respect to necessary amenities such as housing, food, housing and gas related services. Fundamentally, the UK government has structured provision for its citizens to increase their disposable income levels. This clearly provides an overview of the initiatives undertaken by the UK government in context to improvising the overall economic scenario21. The below illustrated graphical representation clearly depicts the initiatives of the UK government in promoting per capita income22. Source 23 Exchange Rate Exchange rate of a nation literally describes the purchasing power of its currency which affects the aggregate demand due to its influence on export and import prices. This variable projects high level of reliance upon multiple other aspects such as inflation rate and governmental debt ratio among others24. Source (25) Clearly, it is evident from the graph illustrated above that the exchange rate of the UK for the financial year 2014 has subsequently increased. Justification regarding this can be provided by taking consideration of the increase within the trade exchange practises within the UK. Moreover, evidence regarding the provision of leniency within the domestic sectors has also contributed towards increasing the exchange rates by considerable amounts. The above facts also reveal how UK has been manipulating its monetary and fiscal policies for regulating its trade practises with other allied nations. The UK government has reduced actual borrowing to reduce possible negative effect on exchange rate and increase its competitiveness in the global market26. Unemployment Rate Unemployment rate is another key factor that hampers the economic growth a nation. Justification regarding this can be provided by taking consideration of the fact that continuous increase in the unemployment rate will gradually hamper the overall revenue attainment process of the nation. Moreover, it will also negatively influence social harmony of a nation. Taking consideration of these aspects, it is worth mentioning that the UK has undergone appreciable amount of improvement within its employment sector27. Evidence regarding such aspects can be attained from the graph illustrated below Source 28 It can be conceived from the above illustrated graph that on the first three quarters of 2014, the UK has brought down its unemployment rates by considerable extent. In this context, the government rather than creating job opportunities has passed on this responsibility upon the small and medium business sectors in context of creating job opportunities. However, the government has projected itself as a supporting unit to those small and medium scale industries by ensuring considerable amount of leniency within its taxation and business establishment policies. The sudden growth of the entrepreneurial business process after the lately occurred recession acted as the main influential factor that helped in reducing the unemployment rate by considerable extent. This initiative undertaken by the UK government also supported it in accomplishing its objective of attaining higher levels of economic growth and better financial stability. Alongside,, the tighter monetary and trade related reforms undertaken by the government also corresponds to the generation of higher value of revenue from the economy and other domestically hosted business processes 29. Conclusion The above discussion has been highly effective in context to illustrating about the four-major macroeconomic factors that has the potentiality of affecting the UK’s economy by intensive levels. Facts mentioned within the discussion specifically illustrate the possible techniques through which the UK government regulates these macroeconomic elements with the prime intention of bringing in appreciable level of economic development in the nation. It has been observed that the UK government has undertaken several measures and strategies to promote the economic growth and attain economic stability. The UK government has framed numerous policies directed towards addressing the challenges that actually erupted immediately after the financial crisis and the economic recession witnessed by the world. The UK government with the intention of attaining sound inflation rate has succeeded in minimizing both its CPI and RPI. The government has also reduced the debt borrowing as a measure to eliminate any potential adverse consequences of exchange rate fluctuation. The UK government has also framed policies pertaining to tax in order to promote small and medium size enterprise while achieving the favourable increase in the GDP growth rate. Similarly, in order to deal with the challenges of unemployment, the UK government has brought flexibility in licensing process of new business establishments. Undoubtedly, the initiatives of the UK government are commendable, yet the UK government has to implement more effective economic policies to ensure long term economic growth and stability. References Bartholomew, L., 2014. Fall in Euro Zone Inflation Rate Fuels Deflation Concerns. BBC News. [Online] Available at: http://www.bbc.com/news/business-25976377 [Accessed January 02, 2015]. Elwell, C. K., 2010. Deflation: Economic Significance, Current Risk, and Policy Responses. CRS Report for Congress, pp. 1-16. EY Euro Zone Forecast. 2014. Recovery Continues, But the Threat of Deflation is mounting. Euro Zone, pp. 1-52. Monaghan, A., 2014. Government Borrowing 10% Higher Than Last Year. Business. [Online] Available at: http://www.theguardian.com/business/2014/oct/21/government-borrowing-10-percent-higher-budget-deficit [Accessed January 2, 2015]. Oxford Economics, 2014. The Impact of Inflation and Deflation on the Case for Gold. Documents, pp. 1-48. Schneider, R., 2014. How Significant are the Deflation Risks in the Euro Zone? Macro-economics, pp. 1-6. Trading Economics, 2014. United Kingdom GDP Annual Growth Rate. Countries. [Online] Available at: http://www.tradingeconomics.com/united-kingdom/gdp-growth-annual [Accessed January 2, 2015]. Telegraph Media Group Limited, 2015. Financial Services Sector Pays Most Tax To UK Government. Home. [Online] Available at: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/8204623/Financial-services-sector-pays-most-tax-to-UK-Government.html [Accessed January 2, 2015]. Trading Economicsb, 2014. United Kingdom GDP Per Capita. Countries. [Online] Available at: http://www.tradingeconomics.com/united-kingdom/gdp-per-capita [Accessed January 2, 2015]. Trading Economicsc, 2014. United Kingdom Unemployment Rate. Countries. [Online] Available at: http://www.tradingeconomics.com/united-kingdom/unemployment-rate [Accessed January 2, 2015]. X-Rates, 2015. Monthly Average. Percent Change in the Last 24 Hours. [Online] Available at: http://www.x-rates.com/average/?from=GBP&to=EUR&amount=1.00&year=2015 [Accessed January 2, 2015]. Read More