How a Fall in Household Savings Can Have a Negative Effect on the UK Macro Economy - Example

MACRO ECONOMICS By + Table of Contents II.THE LIKELY EFFECTS OF MONETARY EASING WITH FIERCE FISCAL CONTRACTION ON THE LEVEL OF UK REAL OUTPUT (IS-LM ANALYSIS). 5 III.CAN CHINA’S GROWTH RATE BE MORE LIKELY TO BE THE RESULT OF FISCAL STIMULUS RATHER THAN MONETARY (MUNDELL-FLEMING MODEL). 8 References 12 I. HOW A FALL IN HOUSEHOLD SAVINGS CAN HAVE A NEGATIVE EFFECT ON THE UK MACRO ECONOMY. Households in the UK have been saving a considerably lesser amount of their disposable income in recent days than in the previous decade. This decreasing saving tendency has been complemented by a poor moderation in household sectors borrowing behavior, which has caused the household sectors gearing ratio destabilize after a decade of decreases (Swan, 2007). A fall or rise on housing savings in UK can very influential, negatively or positively, on the UK’s domestic and nation economics. Household savings is a fundamental aspect influencing national expenditure and income of any nation. This essay aims at explaining how fall in household savings can have a negative effect on the UK macro economy. Household saving has turned out to be a huge macroeconomic problem in the UK in previous years. There was a tendency decline in savings ratio in the late 1990s, for most of the last decade and many people have seen this as a key reasons why the UK economy was at such great risk during the infamous credit crunch. Britain entered the recession and financial crisis with the lowest ever savings rate of all main economies.  Savings kept in bank accounts are key part of money. To the extent banks decide to finance commercial investment with respect to amount of deposits they receive, an increased personal savings could raise investment by the established international organization. If money deposited is changed in equity subscription in ones own secure, savings serve for personal independence and careers, again with a possible connection to investment in a macro-economic sense. Below are some of the key negative effects that come along with decreased household savings: Real interest rates on savings deposits (the nominal savings return adjusted for inflation). When the household saving fall the real return to saving become negative since interest rates paid on current and deposit accounts have collapse whilst consumer price inflation remain persistently above the 2% government’s target. Secondly, expectations of job security and future incomes / all related to consumer confidence it reduced. This is one main reason why we see a rise in savings ratio during recessions. Also, a fall in household savings reduce credit availability such as borrowing to finance surplus spending sums as less saving. The credit crunch makes it hard to get new loans. Less savings means less taxation of saving and tax efficient savings structures such as Individual Saving Accounts. The need of saving to repay debts – an instance would be property owners wedged in negative equity whereby their house are worth less than their unpaid mortgage debt or consumers who have piled up hefty debts in their (expensive) credit cards, now needing to cut back on their spending to lessen existing loans. Invested in the Treasury bonds, and savings finance public expenditure inform of shares, they may directly or indirectly fund the firms. Savings may also be transfer overseas by remittances, leading to rise to a new option between savings and consumption. For instance, in the form of buying an existing house or in funds on entrepreneurial activity). Insufficient and minimized savings due to a deliberate policy to promote the growth of GDP by independent consumption alone can reduce, if the policy is only feebly effective, the national economy capability to absorb treasury bonds, which in certain circumstances may put the country under high pressure by foreign creditors, when public debt is huge and prevalently held by foreigners (Swan, 2007). It is obvious that that a tax cut will increase disposable income. Our consumption theory smoothing tells that households will react by increasing savings and consumption. Specifically, prediction that a dollar worth of tax cuts can cause cause saving to grow by (marginal propensity to consume). It is tempting to conclude that tax cuts therefore will lead both to higher consumption, increasing output now, and to higher saving, increasing output in the future. Such an argument is not right because it looks only at saving by households. We also need to look at the effect of the tax cut on the government surplus or deficit. The paradox of thrift remains an important idea from the Keynesian economics. Reduced saving is observed as negative because it does not provides the money to finance the capital investments needed to promote a long-term economic growth. But if many people in UK start saving more in the same time, it may causes a drop in the consumer demand and even deeper recession. What can be rational and good for an individual can be damaging for whole economy at large, II. THE LIKELY EFFECTS OF MONETARY EASING WITH FIERCE FISCAL CONTRACTION ON THE LEVEL OF UK REAL OUTPUT (IS-LM ANALYSIS). Monetary easing (ME) is a type of monetary policy used by central banks, whereby it purchases financial assets from existing commercial banks and other private financial institutions with the aim of injecting money into the economy, thus lowering interest rates and prompting investments to increase output. Lowering long term interest rates, the monetary easing affects the verdicts on things such as whether or not to purchase a house - or whether to purchase more expensive houses as lower interest rates may make that possible (WorldBank, 2010). So it improves homes affordability also and other things that consumers may desire. This paper attempts to analyze the likely effects of monetary easing with fierce fiscal contraction on the level of UK real output using IS-LM analysis. First, when do we require monetary easing and fiscal contraction? Secondly, how does monetary easing work? Thirdly, what are the effects of monetary easing and how do we measure the effectiveness of monetary easing? The IS-LM (Investment Savings – Liquidity Preference Money Supply) is a macroeconomic model which graphically represents two traversing curves. The investment/savings (IS) curve is income-expenditure model variation incorporating markets interest rates (demand), while liquidity preference/money supply equipoise (LM) curve represents the money that is available for investing (supply). The model explains the choices made by investors as far as investments are concerned with the amount of money that is available and the interest they are supposed to receive. Equilibrium is realized when the amount invested is equal to the amount available for investment. A rise in individual consumer expenditure shifts the aggregate demand upward and moves the IS curve towards the right. A decline backs the analysis direction. For any given interest rates, the aggregate demand function will shift downward, the equilibrium aggregate output level drops, and the IS curve will shift to the left. A growth in planned investment spending unconnected to the interest rate will shift the aggregate demand functions upward. This phenomenon is also realized with an autonomous rise on net exports unconnected to the interest rate. In addition, changes in taxes and government spending are the other two aspects that can lead to shifting of the IS curve. While various factors can cause IS curve shift, there are only two distinct factors that can have same effect on LM curve; changes in money supply, and autonomous change in money demand. Increased money supply results to money excess at points on initial LM curve hence shifting the LM curve towards the right. This excess demand for money condition can be eliminated by rise in interest rates, which reduces the amount of money demanded till it again equals the amount of money supplied. There are many implications of monetary easing with fierce contraction on the level of UK real output. Firstly, prices for the UK services vended to the UK market might fall - banking, government, accountancy, etc. The UK assets price such as housing will as well fall. The prices of goods made abroad and vented in the world market - electronics, energy, food will increase. The inflation/deflation statistics demonstrate the combined impact of these two trends that may be general inflation or deflation - though for many people employed in the UK both effects remain negative. The deflation will cut their wages and the inflation will increase their costs. The government should therefore rebuild technology industry and begin exporting to balance its imports. Unfortunately in the last 10years of extortionate currency and property hike have run down that sector of economy (WorldBank, 2010). The government have to ensure that the money available is directed to promoting exporters: getting venture capitals flowing into technology and lending for bigger firms to finance production. From these analysis, we can draw some assumptions about the economy state and the effectiveness of monetary easing. Monetary easing remains and continues to be an effective strategy in maintaining interest rates low and minimizing risk. Even as risk and insecurity sweeps through financial markets, which threatened a raise in interest rates on mortgage-backed and securities bonds, the UK Reserve’s quantitative easing strategy succeed in combating this pressure. The Central Bank thrive in achieving anti-deflationary strategy without allowing inflation to go excessively high. Inflation up to around 3% is reasonable and somewhat healthy. Moderate inflation and a stable nominal interest rates shows that real interest rates do not rise. Also, GDP is growing, though not fast enough. The Central Bank’s monetary easing strategy was destined to stimulate aggregate demand hence, we would expect to realize that in two processes — the level of unemployment and the level of output (WorldBank, 2010). While output is steadily growing and unemployment is steadily falling, persistently high unemployment together with persistently low growth may be detrimental to the UK economy. The general conclusion of this essay is that the effectiveness of monetary easing depends on the observer’s perspective. By effects of monetary easing with fiscal constriction does well in tackling interest rates, inflation, uncertainty and risk. However, by its effects of growth stimulation and unemployment reduction, the results are mixed. While monetary easing with fiscal constriction may stabilize financial markets, its impact on the economy may, ironically, introduce more risk and uncertainty. This does not imply that monetary easing and fiscal constriction is not a reliable policy, but the situation at hand is unwarrantable because the US and the entire global economy are in anonymous territory. III. CAN CHINA’S GROWTH RATE BE MORE LIKELY TO BE THE RESULT OF FISCAL STIMULUS RATHER THAN MONETARY (MUNDELL-FLEMING MODEL). Central Bank of China – The People’s Bank of China (the PBOC) has largely sustained its monetary policy liberation for the previous three decades (Li, 2013). China actively controls currency’s (Renminbi) exchange rate. Besides, China keeps a strict observation on capital flows. The government liberalized inward financial direct investment (FDI) flow many years by promoting tax benefits as well as other incentives. Control of capital have also played crucial role in preserving the banking system from external inflows by making it exceptionally hard for the foreign banks to setup. The purpose of this essay is analyzing China’s growth rate; whether it is likely instigated by fiscal stimulus rather than monetary factors using Mundell-Fleming model. The Nobel Laureate and economist Robert Mundell with Marcus Fleming established an economic model popularly known as “Mundell-Fleming Trilemma”. This model’s basic principle is that Independent Monetary Policy, Free Capital Movement, and Fixed Exchange Rate, cannot be maintained concurrently. Looking at China’s economy growth, it will be reasonable to say that the government is trying to achieve all the three concurrently. China’s efforts to control cross-border capital out-flows have never been too effectual. China implemented some strong actions to stop capital outflow at the peak of the infamous Asian crisis (1997-98). Investors started putting in money in the early 2000s in anticipation of currency exchange rate rise. In the course of 2004-06 investments were made due to the rising asset prices (Li, 2013). China undertake heavy sterilization to control all three policy goals given by the Mundell-Fleming model. China has been running the Current Account Surplus (CAS) in a span of the last 30 years and the Trade Surplus every year from 1993 (Li, 2013). To pressures currency exchange rate manage, China engages comprehensively in foreign-exchange market. The Mundell-Fleming model, to some extent, demonstrates that the monetary and fiscal policies effectiveness differs depending on the degree of capital controls and the kind of exchange rate regime. For example, in a nation where capital movement remains free and exchange rates remains fixed, the monetary authorities cannot track an independent monetary policy. A country that has a fixed exchange rate regime embracing no exchange rate risk, the domestic interest rates change in close level with the foreign interest rates, those with assets denominated in a currency to which the nation’s currency is pegged, due to the interest rate arbitrage functioning. Under this condition, the monetary authorities are incapable of determining money supply in their own, just as they become unable to find control over the interest rates, since any attempt to adjust money supply would be refuted by the offsetting outflow or inflow of capital from or to the country. In China, unlike other developed economies, sterilization and monetary policies in wider perception, are the same. The monetary policy stretch depends upon the degree to which liquidity is sterilized by the market interventions. People’s Bank of China involves in two types of sterilization programs: a) through open market activity with treasury bonds, and from 2003 it has been vending central bank bills to the commercial banks; and b) by increasing banks’ Cash Reserve Ratio. Current CRR stands at 20%, nearly double that of US banks (Li, 2013). The price of sterilization, keeping China’s currency undervalued than its actual value has kept the supremacy and importance of the US Dollar steady, prevailing at the China’s exchange rate internationalization program expense. China has trebled the bond sales quota by local governments to up to Rmb1.5tn ($240bn) in attempt to shunt some of their large debts back on balance at lower interest rates. Ultimately this is projected to reach Rmb3.5tn by the local media. Local governments have accumulated huge debts, largely off- the- balance sheet, as they spend binges designed to indorse growth and gild the official’s reputations. Borrowing through 10,000 Chinese local government finance vehicles cost nearly $3tn. Economists widely welcomed the move, arguing it created more transparency and enabled local governments rolling over short-term loans into the government bonds which invesely cost less to service. This has also shows Beijing is changing from monetary to a fiscal policy levers seeking to cushion a go-slow in the economy without worsening debt glitches. The quota got raised two days after the finance minister, Lou Jiwei, said that the fiscal deficit for year the 2015 would be higher than formerly indicated. High quality global journalism requires investment. Please share this article with others using the link below, do not cut & paste the article. Economists contemplate that fiscal spending on the infrastructure is key to maintaining China’s general growth this year amidst slowdowns in manufacturing and real estate, key sectors that have boosted China’s economic boom in recent years. Sterilization also brings about some hidden disadvantages with itself. Firstly it leads to misallocation of resources because it is the export sector that gets most of the advantages. Sterilization gives the country’s exporters benefit at the expense of the other sectors. The small and medium-scale industries which yield non-tradable goods get limited access to government’s gentleness. High CRR and compulsory purchase of the central bank bills minimizes the commercial banks’ profits. China’s banking sector needs urgent treatment, quest for yield on prevailing funds will make banks investment in riskier projects. The model of Mundell-Fleming consequential expansion into the "impossible trinity," principle - no country can achieve the three free capital mobility, a fixed exchange rate system and independent monetary policy goals, simultaneously has made China pursue an independent monetary policy while controlling a fixed exchange rate system which is practically a dollar-peg, by controlling capital movements, such as, offering free capital mobility. After its agreement the World Trade Organization, China’s capital mobility has augmented and the country is now being obligated to shift to floating exchange rate system so as to maintain an autonomous monetary policy, but many economists have continued to maintain that China should have their fixed exchange rate regime. Supply improvements might minimize the risk of inflation or develop the output quality but people still need to purchase the output to promote growth and innovation. A related assentation is that fiscal stimulus intended at fostering growth will lead to inflation and become self-defeating. This opinion prevails in mainstream macro-economics as taught in the institutions allover. Some mainstream economists qualify this opinion and give conditional sustenance to the fiscal stimulus answer by appealing to what is termed the “liquidity trap”. This technically proves that China’s economic growth rate cannot be more dependent on fiscal stimulus rather than monetary stimulus, but the vise-versa. References Li, J., 2013. Chinas Economic Dynamics: A Beijing Consensus in the Making?. 2nd ed. London: Routledge. Swan, C., 2007. Study Guide to Accompany Macroeconomics: Principles and Policy. 7th ed. London: Dryden Press. WorldBank, 2010. Global Economic Prospects 2010: Crisis, Finance, and Growth. 1st ed. New York: World Bank Publications. Read More