Economic Performance of the UK - Coursework Example

Contents Contents Introduction 2 Recent Economic Performance of UK 3 Inflationary Pressures 4 Lowering Interest rates 5 Conclusion 6 Bibliography 7 Introduction Most developed nations of the world including US and UK are experiencing an economic meltdown causing serious economic problems for both the countries. The results of such an economic meltdown are serious because it not only affected the financial system, but it has been also serious hampered the economic growth. The credit crunch has been serious created the shortfall of banking credit to firms to fund their expansion plans as well as working capital needs, but it has also put extra pressures on the resources of the financial institutions as especially banks are finding it difficult to cope with the increasing defaults and foreclosures in mortgage market. UK's economy is experiencing slower growth as during 2007, it recorded a real GDP growth of 3.1% however, and the same has been recorded at 1.0% due to sharp increase in inflation. (Economist.com 2008). UK's inflation touched 3.8% in 2008 whereas its budget balance also widened to negative 3.8% suggesting the fact that all is not well for the UK economy. Many critics believed that in order to arrest the rising inflationary trends in the country, the monetary authorities in the country shall increase interest rates whereas some believed that in order to reduce the impact of recession, UK's monetary authorities shall lower interest rates so that economy can be put on right track. This paper will discuss both the options i.e. increasing or decreasing the interest rates to control inflation or avoid recession and will present a comprehensive analysis of both the options in order to provide a conclusive recommendation of which option to exercise. Recent Economic Performance of UK The economy of UK is second largest economy in EU after Germany and fifth largest economy in the world. It boasts one of the significant economic performance within the region during recent past as UK economy witnessed lower taxation as well as relaxed regulatory environment which allowed firms to expand and innovate in order to increase their overall economic impact on the UK's economy. UK's economic performance has been amazing as during past few years, economy recorded consistent growth in terms of economic output. The key economic indicators suggested improvement as UK economy thrived on increasing consumer spending however, due to increasing spending; UK economy witnessed growing increase in its consumer price index. IMF, during 2007, revised its economic forecasts for the UK economy due to its improved performance and termed it "impressive" as during last five years i.e. 2003 to 2007, it recorded an average real growth rate of 2.8%. (BBC.com 2007). The economic growth however is mostly dominated by the service sector with major contribution being made by financial services, food chains, healthcare as well as real estate. Further, the Agriculture sector is also significantly contributing towards the GDP of the country as it meets almost 60% food demand of the country. (Economywatch.com 2008) It is also however important to note that the performance of GBP Pound sterling is also declining over the past few years, mainly due to strong performance of Euro against major currencies and the fact that most of the trade within EU region is dominated by Euro. The recent developments, especially in the later half of the year 2008 however suggest that all is not well with UK's economy as it is experiencing serious challenges ahead due to the spread of subprime mortgage crises originating from US. The housing sector in UK thrived on the loose regulatory environment which allowed lenders to make lending into areas which were not considered as bankable under normal circumstances. UK also experienced the same economic bubble in its housing sector as not only the prices of the housing units dramatically increased but also the overall flow of credit to the housing sector increased too. This not only made bankers less prudent while lending to subprime borrowers but also encouraged them to engage themselves into financial innovation which resulted into the subprime mortgage crisis which UK is also experiencing along with US. The recent efforts by the government of UK including Bank of England. Bank of England, at least in first half of current year, was focusing on containing inflation, and it increased the interest rates also however, the recent massive failures of few of the most prominent financial institutions including Lehman Brothers suggested that the immediate focus of the monetary authorities should be to lower interest rates in a bid to ease out the lending environment for financial institutions so that lending activity can take place. Inflationary Pressures As discussed above that the UK's economy is experiencing rising inflationary pressures in its recent past and Bank of England, the central bank and monetary policy regulator of the country raised interest rates in order to contain the rising inflation in the country. Many critics believed that Bank of England should further increase the interest rates in order to contain inflation as it was believed that inflationary pressures may erode the real growth of the economy. This argument was put forward because numerous empirical studies suggested that real interest rates influence the spending decisions of both the firms as well as households therefore inflation play a critical role in defining the real growth of the economy. (Brzoza-Brzezina 2001). The underlying assumption behind this inference is based on Fisher equation which states that "nominal interest rates equals the real returns plus the expected rate of inflation" (Walsh 2003) thus the nominal rates are considered as positively related with the expected inflation. Based on these theoretical assumptions, critics believed that if interest rates are increased by the monetary authorities of the country, it will help to rationalize the inflation within the economy because by raising the interest rates, the cost of borrowing would increase which would, in return, make the spending more expensive hence consumers will prefer to limit or rationalize their expenditures and inflation will be controlled due to reduced aggregate demand. Various studies suggested that the interest rates are positively correlated with the average inflation rates in long run however short run relationships between the two variables varies between countries as individual economic variables behave differently to the short run policy measures of the monetary authorities. Lowering Interest rates As discussed above that the immediate concerns for Bank of England is to regulate monetary policy in a such a way that it can avoid the emerging recession which is looming over UK due to mass scale failure of world's financial system. The immediate impact of the credit crunch has been the crowding out of the genuine credit flow to the industrial sector so that the necessary goods and services can be produced to stimulate and sustain the current levels of consumer spending therefore, it has been advocated that monetary authorities should lower interest rates in order to create easy money not only for financial institutions but for consumers i.e. households as well as firms. Providing credit at much cheaper rates will not only provide an opportunity to firms to engage into expansion but also continue to produce at least at their normal capacity levels therefore, not only economic activity will pick up but consumers will also find it easier to spend on easy credit terms. The above argument is also strong because increased economic activity will help government to avoid the recessionary phase of the business cycle as sustained levels of consumer spending coupled with the consistent production i.e. aggregate supply would ensure that the economy will at least maintain its current pace and will not make an steep dip to negative growth. Conclusion Considering the current economic situation of the country and emerging economic challenges it is going to face, it would be wiser for monetary authorities in UK to lower the interest rates in order to avoid the recession. This is due to the fact that inflationary pressures on an economy are sometimes cyclical in nature and can be avoided using short term monetary policy options however if UK economy faces a recession than it may be uncertain to accurately predict as to whether this recession would turn into depression or the cycle will reverse to peaks. Further, current facts are hinting to many grave consequences of the potential recession which UK economy may face because it will not only impact its industrial sector but the services sector will also get affected more badly as in comparison to the past. As discussed above that the financial sector is the largest contributory in the overall services sector of the economy therefore with the current crisis being faced by the financial sector, it is necessary that the next policy steps shall be directed towards correcting the financial system as it is the worst hit sector of the economy. Based on the above assessment of facts, monetary authorities in UK shall lower interest rates in order to head off the looming recession because if it is not done, the consequences may be much severe than expected by most of the critics. Bibliography 1. BBC.com. "IMF upbeat on UK economic growth." BBC. March 05, 2007. http://news.bbc.co.uk/2/hi/business/6421087.stm (accessed December 12, 2008). 2. Brzoza-Brzezina, M. "The Relationship between Real Interest Rates and Inflation." National Bank of Poland. 2001. www.nbp.pl/publikacje/materialy_i_studia/23_en.pdf (accessed December 12, 2008). 3. Economist.com. "Economic data ." Economist.com. 2008. http://www.economist.com/countries/britain/profile.cfmfolder=Profile-Economic%20Data (accessed December 12, 2008). 4. Economywatch.com. "UK Economy." Economy Watch. 2008. http://www.economywatch.com/world_economy/united-kingdom/ (accessed December 12, 2008). 5. Walsh, Carl E. Monetary Theory and Policy. New York: The MIT Press , 2003. Read More