The Macroeconomic Theory - Essay Example

Page Introduction: The aim of the paper is to understand and analyze the Macroeconomic theory in coherence with the current macroeconomic conditions prevailing in the UK. The paper will illustrate the determinants of macro economy and the role they play in making policy and interest rate decisions. Most of all the paper will detail the importance of interest rate ceiling initiated by the Bank of England to control and promote a healthy economy. It will analyze the trend in the interest rate and correlate the same with growth and point out areas of weakness or areas, which affect the economy as a whole and recommend and interest rate to the bank, which can be implemented for the rest of the year 2008. Understanding Macroeconomics and Macroeconomic Policy Macroeconomics is the big picture of a country. The rate of inflation measured by the Consumer price index, Growth measured by the GDP rate, and the rate of unemployment, which denotes the country’s full employment potential. On the other hand, Microeconomics is study of the behavior of firms workers, markets and households. The primary goal of the government and the Bank of England is to keep inflation and unemployment as low as possible in the process of maximizing growth. To achieve this goal a monetary and fiscal policy is formulated. A monetary policy is the altering of lending rates to banks this in turn releases or curbs money supply in the financial market. An increase in the prime lending rate by the Bank of England to other banks pushes them to raise the interest paid on deposits to consumers and the interest on loan to borrowers. A fiscal policy is the change in the taxation structure and public spending. Public spending in other words is the government spending on defense, infrastructure and welfare schemes for the country. (Source:Mathew Bishop ’Economist’ Essentials of Economics, Macroeconomic policy.) Page 2 Inflation is caused when demand for goods and services exceed supply or a rise in the price of oil, which most countries around the globe are facing right now. An increase in the prime lending rate will encourage saving, and discourage borrowing due to the high rate of interest on loans and in turn bring down consumption spending by giving the common person, lower disposable income, Therefore lower demand and this controls price rise. Now the reduction in consumption spending decreases the demand for goods and services, and businesses will cut cost as they worry about inventory pile up and future sales. This results in low wages and unemployment. So what do we do? What we see here is ironical. In the attempts to curb one aspect of macroeconomics- Inflation, we end up in the deterioration of the other two, growth and employment. Do economic policies offer salvation? Most of the time it is difficult to predict the trends in the economy after any change in policy. The changes are time lagged and may not occur as early as expected or sometimes may even skip stages in the cycle. What we clearly know is the balance that should be maintained in order the ensure stability and growth. Spending power needs to increase for demand creation and the facilitation of industrial growth. A change in the fiscal policy can also help neutralize downward economy by leaving more disposable income in the hands of the consumer. However, this is again a balance to be maintained by the careful blending of monetary and fiscal policies .Global factors, local factors, and all aspects of microeconomics play a key role. Definitely, inflation or deflation can never be zeroed down or always be maintained at the targeted rate. It can only be brought close to the targeted rate and with the best efforts of the bank and government contained within a desirable range. However, one should not ignore the fact that a bad macroeconomic policy can push a country into recession. Page 3 The current Macroeconomic situation in UK. The major threats for the UK economy is the growing Inflation and the declining GDP.The CPI is up straight from a 2.3 % in the beginning of the year to 3.3% at the end of May 2008 with absolutely no pitfalls in between. The rise in crude oil price is quoted as the reason for this sharp and steep increase. The GDP of the country for the quarter ended was at 0.4% against an expectation of 0.6 %.The unemployment rate is up to 5.3%, which is a 0.1% up compared to the previous quarter but down to 0.2% when compared over the year. With an increase in demand for goods and services, we can see the unemployment rate coming down further the 0.2% down as compared to the whole year is actually a positive sign in the midst of the storm cloud.(Source:HRM guide, Labor Market statistics, UK statistics authority) The rising inflation erodes consumer saving and investments and affects the GDP of the country the current GDP rate for first quarter of 2008 rose by 0.4 % as compared to the fourth quarter of 2007. As Jonathan Loynes, Chief European Economist of Capital Economics says, “This 0.4% gain in the overall output was driven by increases in consumer spending and government spending, both of which are likely to be far weaker in coming quarters as consumers are hit by falling house prices and high inflation and public spending is squeezed.” (Source: Hopkins Kathryn, Business news’ The Guardian’) The reduction of consumer savings and the cut back by firms on new investments can only mean an even more severe downturn in the economy or a negative GDP rate in the forthcoming quarter. The fear of recession is catching up, as the GDP numbers for the United States also do not look healthy. The GDP trend along with the inflation in the country can push the Bank of England to lower the the interest rate. Page 4 The of Macroeconomics data of UK look rather tight and the Bank of England along with the government have a challenging year ahead in implementing monetary and fiscal policies. The rising inflation has to be controlled and consumption spending also increased for growth. The country has to facilitate firms to invest, employ, foresee demand for products and services, and make available credit, for expansion. Role of the Bank of England. The Bank of England founded in 1694 and stands as the centre point of United Kingdom’s financial system. The primary aim of the bank is to promote and maintain financial and monetary stability to ensure a healthy economy. In short, the bank is the government’s banker and the banker’s bank. The bank is the custodian of UK’s foreign exchange and gold reserve. It is the sole issuer of bank notes in England and Wales. The interest rate decisions are part of the monetary policy of the bank. The bank is entrusted with the important responsibility to safeguard the value of its currency in terms of what it can purchase. Inflation or a rise in the Consumer price index reduces its value. (Source: Bank of England, ‘About the bank’, core purposes) When the Bank of England raises the official interest rate, Commercial banks increase the rate of interest on deposits to attract savings, and raise the interest on loans to discourage borrowing so the free cash flow in the market is cut and spending reduced. The opposite happens when the interest rate is lowered. The 300-year-old bank has undergone many changes and has seen many trends in the British economy. The Bank of England has targeted inflation rate of 2%. However if this target is higher or lower by a margin of more than 1%. The bank is required to offer and explanation to the Government regarding the increase or decrease. Currently the bank maintains an official interest rate of 5%. Page 5 A comparative analysis of UK’s current macro economic and historic data In order to get a clear idea of the current situation in the UK, and how the interest rates affect consumption, inflation, unemployment and the Gross domestic product, let us compare the current inflation and interest rates with relevant historic inflation and interest rates. We have chosen the year 2001 for comparison, as it is a one, which set a precedent for the current year by having similar inflation rates The below tables reflect the big picture of the current UK Economy. Table 1 Year Month Inflation Interest rate GDP rate 2008 May 3.3       April 3 5     March 2.5   0.4   February 2.5 5.25     January 2.2     2007 December 2.1 5.5 0.6   November 2.1       October 2.1       September 1.8   0.7   August 1.8       July 1.9 5.75     June 2.4   0.8   May 2.5 5.5     April 2.8       March 3.1   0.7   February 2.8       January 2.7 5.25   Source: Money Extra, AWD Direct Ltd., Updated on April 2008, Inflation History. 2007-2008 Page 6 Table 2 2001 Inflation Interest rate GDP Jan 1.8 6   Feb 1.9 5.75   Mar 1.9 5.75 0.5 Apr 2 5.5   May 2.4 5.25   Jun 2.4 5.25 0.6 Jul 2.2 5.25   Aug 2.6 5   Sep 2.3 5 0.3 Oct 2.3 4.5   Nov 1.8 4   Dec 1.9 4 0.1 Source: Money Extra, AWD Direct Ltd., Updated on April 2008, Inflation History. 2001. BBC News GDP rates., ONS – 23, July, 2002 If we look closely at Table 1, which depicts the Inflation, Interest rates and GDP, It currently shows a rising inflation and a deteriorating GDP. The reason is the high interest rate hold - out by the bank the whole of 2007. The bank of England has maintained an average of 5+% points as the Interest rate through out the year 2007, but has kept lowering the rate from the end of 2007. Possibly the bank has not ignored the decline in the GDP. Despite a high interest rate of 5.75%, inflation has not lost steam from the beginning of 2008. The reason the rise in oil prices. Page 7 After a complete crunch on consumer spending by keeping the rates high the whole of the year 2007, Inflation is still on an Upbeat. Table 2 shows a similar picture a declining GDP after a high interest rate hold out. Table 2 shows evidence of recent history on Inflation and Interest rates.2001 was the only year just before 2007 where the bank had handled such a volatile rate of interest. It is this success of the bank in holding out an aggressive interest policy against inflation, which encouraged the bank to continue on the same principle for most part of the year 2007 and did succeed to an extent. The Bank of England has reason to believe that a high interest rate will definitely bring down inflation and this is evident in both Table 1 and Table 2. The inflation rates in March 2007, and April 2007 were brought down considerably with the interest rates and the bank had done a commendable job on inflation in the last 2 quarters of 2007. However, the declining GDP is posing a threat to the Economy. Depositors are unable to see the value of their saving with the rising inflation. Moreover, firms facing a crunch on credit for any new investment and are wary to venture and expand therefore leading to lower productivity and resultant unemployment. The GDP figures for the First Quarter of 2008 are even more alarming. When we look at the above trends it is evident that there has been a liquidity crunch due to the high interest rates and though there is a demand, supply is unable to match or meet demand requirements. The credit crunch felt by the firms fed through their new investment and expansion plan and customers are paying a higher price for the same goods and services resulting in the soaring of the Consumer price index. Page 8 Recommended interest rate. However, the bank was quick to act against a receding economic growth. It has turned on the hopes of a further reduction in the interest rate in the forthcoming quarters of 2008. The current interest rate of 5% can be lowered to 4.75% by the end of the year thereby releasing cash flow back to commercial bank to facilitate business and create demand. The country should not ignore the long-term growth and this can happen only with free flow of cash. Curbing demand leads to pessimism in the market. Trade can come to a standstill. In endlessly chasing inflation, the macro goals of a country can be ignored. It is important to revive economy and accelerate growth rather than work backwards and bring down consumer spending. Of course, the Bank is playing its part well despite the rise in crude oil prices. Conclusion: A recent article in the “Telegraph” had this important detail.’ A saver who deposits £ 10,000 in an account, which gives him an interest of 4 %, will receive £10400 at the end of the year. A higher rate taxpayer will have to pay 40 % that is £ 160, and this leaves him with £ 10240. In the same period if inflation is at a 3% the prices of £ 10000 worth of goods will be £ 10300 leaving hi with a deficit of £60.’ After a year of acceleration on interest rates, it is time for the bank top release flow of cash in the market and ease the stifling liquidity crisis. The decline in the GDP only refers to the statements made by Jonathan Loynes early in this assignment the squeezing of savings coupled with high inflation will lead to a weaker economy.(Source: Lea Ruth, Reported by Wallop Harry, The Telegraph ) It is time for the bank to put more disposable income in the hands of the consumer and increase purchasing power the demand supply curve will adjust to create a healthier economy as business will flourish on the prospect of future demand and the available cash in the market will create favorable conditions for new ventures and investment. It is recommended that the Bank of England continue to lower the rate of interest in the quarters to come to a 4.75%. This interest rate will still keep a tab on inflation and give a start for a turn around in the GDP. Page 10 References. Mathew Bishop, 2005, Essential Economics, Macroeconomics and Macroeconomic policy, Website of ‘Economist’. Retrieved on 25/06/08, www.economist.com UK Statistics Authority, Updated on 25/05/08, UK Snapshot, Economy, Latest Indicators, Inflation, Unemployment rate, Website of UK statistics authority, Retrieved on 24/06/08. www.statistics.gov.uk UK Unemployment, Labor Market statistics, Updated 11/06/08, HRM Guide, Retrieved on 25/06/08, www.hrmguide.co.uk Loynes Jonathan, Reported by Hopkins Kathyrn, Updated on 28/05/08, Guardian, Business News, Retrieved on 24/06/08, www.guardian.co.uk Bank of England, Official Website, About the bank, CorePurposes, Retreived on 26/06/08, www.bankofengland.com Money Extra, AWD Direct Ltd., Updated on April 2008, Inflation History, Interest rate History, Retrieved on 25/06/08, www.moneyextra.com Lea Ruth, City Economist, Advisor- Arbuthnot banking group, Reported by Harry Wallop, Updated on 26/05/08, ‘Savers suffer as inflation tops interest rate,’ Newspaper Telegraph, Retrieved on 25/06/08, www.telegraph.co.uk Read More