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]

~END OF PAPER~

Answer 1

A) (i) The level of household consumption in UK are determined by the following factors:

• One of the factors considered is inflation. Inflation shows the change in prices of consumer basket in the economy. A rise in the inflation rates would mean that the prices in the economy has risen thus discouraging spending by the conumers. This decrease in spending shows the reduction in household consumption.
• Another factor determining the household consumption is the availibilty of credit in the market. According, to the above report ease in credit availabilty would not improve consumer spending due to hard hit recession.
• Another factor that can be considered is the employment rate. An increase in umemployment rate would mean more consumers not having enough money to spend thus reducing the household consumption level overall.

(ii) A discretionary fiscal policy mean the measures taken by the government. These measures are mainly in the from of government spendings and taxes. A discretionary fiscal policy is a demand side policy adopted by the government to boost demand in the economy. In order to boost demand, government could either lower taxes or increase it's spending. By lowering taxes in the economy, government is trying to boost demand in way that, with lower taxes the disposable income of the people will increase. Increase in the disposable income would mean increase the ability of consumer to spend thus increasing the demand for goods. This increased demand would encourage producers to produce more thus increasing the capital formation in the economy, thus giving a boost to the entire economy overall. Similarly, increase in government spending would also help the economy.

Quantitative easing is a monetary policy under which central banks pumps money into the economy by buying back long term securities from open market. With this, the money supply increases. Increasing money supply lowers the cost of money which leads to lower interest rates. This quantitative easing policy of the central banks can sometimes lead to increase in inflation in the economy. This is because many a times increase in the money supply would not impede the neccesaary economic growth needed thus inflating hitting back the economy hard.

C) When there is a slump in the economy then the Centrak Bank adopts an expansionary monetary policy to help boost economic acitivity. The main objective of this policy is to boost aggregate demand in the economy. Under expansionary monetary policy the money supply in th economy is increased. The main aim of increasing money supply is to make liquid money available to consumers that would help increase the demand in th economy and thus lead towards economic growth.