Question

Section B

Read the extracts and then answer all questions.

Extract 1

Bank of England’s Monetary Stance The Bank of England must maintain a very expansionary policy as the economy is still in a precarious situation. There has not really been much of a recovery from what was one of the deepest recessions in the history of this country. I think where monetary policy needs to be right now is to maintain a very expansionary stance and try to boost demand as quickly as possible. It is likely that wage settlements will remain subdued and that is one of the reasons why it seems to me pretty likely that inflation will continue on the downward trajectory. Falling inflation should also help hard-pressed households, finally ending the price squeeze on their disposable income. That will really change the dynamics of consumer spending. ‘However, consumer spending was unlikely to be fuelled by easy credit. I think it will be foolish to expect the availability and cost of credit to households and companies to go back to relatively easy conditions we were in the years leading up to the crisis.’

Source: D. Miles, 23 February 2012.

Extract 2

Failure of Monetary Therapy

In late 2008, UK economy was in intensive care. Jobs have been lost in a massive scale, and business has evaporated. The Bank of England has already cut interest rates by 3.75% from their peak in summer of 2007 to just 2%. Yet, the news from the patient has continued to get worse. Central banks’ great fear is that as the economy deteriorates, interest rates are cut close to zero, and inflation gets very low or negative, the economy slides into an abyss where no one feels like spending, or making new investments, everyone hangs onto their cash, and the economy is driven ever further into decline. That is where Japan got stuck during its ‘lost decade’ of the 1990s – in which prices were plunging, anxious consumers were wary about spending money, and recession and deflation went hand in hand. Fear and uncertainty themselves can have a powerful impact on economies and blunt the effect of monetary action. In the UK, firms became incredibly cautious when uncertainty went up: they did not react to either good or bad news. Within the Bank of England, there was a rising fear that with interest rates at 2%, the Monetary Policy Committee was pulling down hard on the main lever it has at its disposal, but little was happening at the other end. The ineffectiveness of monetary policy was further compounded by the parlous state of the banking system, which was preventing the benefits of interest rate cuts from being passed on. For many businesses, and hopeful first-time buyers, low rates of interest were almost meaningless, as they struggle to get a loan at all. Banks that have seen their balance sheets ravaged understandably have little enthusiasm for making risky new loans. As cash-flow problems mount among businesses, there was a risk of widespread insolvencies and mass layoffs. That could create a nasty feedback loop, as more borrowers default on loans, inflicting yet more damage on banks’ balance sheets. The central bank governor, Mervyn King, is keenly hoping the weaker pound will help the economy to recover strongly once the global downturn is over, as world trade picks up; but if scores of firms have gone bust through lack of funds, there will be fewer exporters to take advantage of rising demand, and recovery could be slow and sickly. Even if every dose of monetary policy medicine is passed on to ordinary firms and families, once rates get close to nought, it may be time for a fresh approach- which is why King and his colleagues are beginning to weigh up quantitative easing. If orthodox monetary policy is not working terribly well at the moment-quantitative easing is going to become a consistent theme. That would be a radical, risky measure, threatening inflation further down the line; but these are not normal times. As the US economy lurches deeper into recession, the UK’s prospects look increasingly grim. King may soon decide it is time to resort to the monetary equivalent of shock treatment.

Source: Adapted in part from The Guardian, 7 December 2008.

A) i) Drawing upon both extracts, identify and explain three factors which determine the level of household consumption in the UK economy. [6 marks]

ii) Explain how discretionary fiscal policy works? [6 marks]

B) Extract 2 asserts that ‘jobs have been lost in a massive scale, and business has evaporated.’ In relation to the above statement, how far do you think quantitative easing is a correct policy action although it would be ‘radical, risky measure, threatening inflation further down the line’? Discuss in terms of inflation and unemployment costs perspectives. [12 marks]

C) Explain how expansionary monetary policy is supposed ‘to boost demand’(Extract 1). [9 marks]

D) ‘The Monetary Policy Committee was pulling down hard on the main lever it has at its disposal, but little was happening at the other end’ (Extract 2). Using appropriate economic reasoning, evaluate in the context of the extract why this might be the case. [7 marks]

[Total: 40 marks]

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Answer 1

A)three factors which determine the level of household consumption in the UK economy are price levels, interest rate and uncertainty. Falling prive levels rise the real income of consumers so they can boost spending. If interest rates are near zero level, then the economy falls in liquidity trap where people are just hoarding money. Finally, in uncertain times, people do not react to any type of information and hence the spending does not increase or decrease.

B)2 lines that assert that ‘jobs have been lost in a massive scale, and business has evaporated’: "It is likely that wage settlements will remain subdued " (Extract 1) and "As cash-flow problems mount among businesses, there was a risk of widespread insolvencies and mass layoffs" (Extract 2).
Quantitative easing refers to a combination of fall in interest rates and large scale selling of assets. The measures seeks to kickstart businesses and prompt them to make investments. However, even if banks make loan at lower interest rates, borrowers may be unable to repay because they have no jobs. Also, there is no demand so businesses are shutting down. This can deteriorate the financial sector. Hence, quantitative easing might not be the best policy.

C) Expansionary monetary policy reduces the interest rate in economy. It has 2 implications: 1) People are de-incentivize to save because of low returns and hence resort to spending; 2) Lowers the cost of borrowing money to consume or invest

D) Even though Monetary Policy Committee was pulling down hard on the main lever it has at its disposal, but little was happening at the other end’ because, it is mentioned that Banks are wary of making new risky loans and they already have a deteriorated balance sheet. So, they are more risk averse and does not want to loan out to new businesses or people. Hence, economy cannot take advantage of low rates due to transmission problems. there is also uncertainty in economy which refrains people and businesses from taking out loans.