Economic Growth In The Uk

Published Date: 02 Nov 2017

Student Name: Sanna Ul-Haque

Student Number: 11038667

Program: Economics, Finance & Int’l Business

Module Name: Macroeconomics 2

Module Number: U52031

Date of Submission: 03.05.13

Declaration of Originality

By signing this assignment, I, hereby, declare this work represents my own effort, and that all content has been written by me and has not submitted for use of assessment in another course or class, except where this has been notified and accepted in advance.

Signature of Student

Introduction

At present, the UK economy is not very well-positioned and facing many challenges. With an economy very open to investment and trade, and highly exposed to developments in global financial markets, the UK was hard hit by the economic and financial crisis. The country witnessed a good GDP growth prior to the crash which was artificially elevated, backed by high spending on account of low interest credit. UK’s major export markets in Europe are struggling at the moment due to the backlash of the recent economic downturn. Performance of inflation is weak because demand is genuinely weak, companies are cutting their prices and the cost of energy and other global commodities is collapsing. A modest recovery is now under way, but the effects of the crisis, on output, on employment and on government accounts, linger. Potential output, unemployment and fiscal accounts have deteriorated harshly, with large deficits and rising debt levels. (Sentence A. 2012)

UK is deemed as one of the last major economies which have shown the sign of being out of recession following Germany, France, Italy, U.S., India and Japan (indexmundi 2013).. Today, the country is experiencing some favorable trends with improved growth rate in different business sectors. In recent months, the growth rate in transport, communication and storage services improved by 0.7 percent while that of government services was registered 0.2 percent. The service sector also registered 0.4 percent rise in last quarter due to a significant boost in automobile, retail, distribution and sectors. The manufacturing sector has seen the same growth rate of 0.4%. (Trading Economics, 2012)

Economic growth in the UK

From domestic factors

IS-LM Model

The IS curve shows the negative dependency that planned investment has on interest rates. The LM curve shows the positive dependency that money demand has on income. The IS curve for that reason is downwards sloping and the LM curve is upward sloping (Mankiw 2008). In the labour government as mentioned before, the expansionary fiscal policy consisted of lower taxes and increased government expenditure. The following shows an IS-LM analysis of the expansionary fiscal policy of the labour government.

5.5 %

5.75%

LM

RFigure 1.1- Expansionary fiscal policy under the labour government

Y

Y1

IS

Y

IS 1Figure 1.1 shows that when government spending increases, the IS curve shifts outwards, creating a new equilibrium at Y1 and pushing the interest rate up to 5.75% from a previous 5.5%. The reason as to why the interest rate increases is due to the increase in money demand which occurs when output and income in the economy are increased. (Boyes & Melvin, 2010). The effect of an increase in the interest rate then has a decreasing effect on investment due to the negative relationship between interest rates and investment. Investment as a result falls.

Figure 1.2- Tax cut under the labour government (Fiscal measures)

Figure 1.2 shows a tax cut similar to the labour government approach. As shown in the diagram, a tax cut has an equal effect as an increase in government spending. A tax cut causes the IS curve to shift outwards because a tax cut induces more spending in the economy, and the interest rate increases because there is more demand for money in the economy (Boyes & Melvin, 2008).

The economic environment in the UK witnessed a positive effect of its few domestic forces:

Improved labour market: Employers have started taking more people on employment due to the gradual decline in real wages over the past three to four years, due to recession and stagnation. A national move towards austerity has lead employers to cap wages below the rate of inflation as well. With the relaxing of these measures, wages can now begin to increase. Hence, more labour activity is seen in the economy, as businesses begin to hire again. (Heath, 2012)

Positive economic indicators: There have been slight improvements in some recent economic indicators, which have included a rise in competitive attitude, increasing exports and a stable housing market. The services sector purchasing managers index has gone up, its manufacturing counterpart is shrinking by less, exports are increasing again, real wages are falling at a slower rate and the housing market seems more or less stable. (Heath A. 2012)

No easy money: After the crisis, the central bank and other banks became more cautious about easily available money and capital and their regulators also encouraged them to build stronger capital reserves. A cavalier monetary policy of loans and risk led many banks to take on higher risk clients, many of which could ill afford to pay back what they owed. After the collapse, regulations tightened and loans were not so easy to acquire. So, the concept of "easy money" is fading day-by-day, which was the prime cause of financial crisis. (Milas & Martin, 2009)

Business confidence and investment: Business confidence has improved from the last few quarters, although it remains weak as compared to historical standards. Manufacturers are planning to invest in plant and machinery which has increased by +17 per cent, while intentions to invest in training increased by 7 points to +17 per cent. (Hamiton, 2012)

No cheap imports: The UK consumers have minimized spending, thus their purchasing power on cheaper imports from China and other low-cost economies. Therefore, growth in these high-growth economies added to the world demand for energy and other commodities. Also, the rising wages in China and other low-cost producing countries pushed up the cost of imported manufactured goods. Demand for commodities is increasing with stabilizing and rising wages. Reducing the dependence on imported materials and overseas reprocessing is clearly a strong argument for economic growth. (Jones, 2013)

From international macroeconomic developments

ECB: European Central Bank (ECB) increased liquidity to the banking system in the Euro nations to mitigate the effect of crisis. The Euro market is the largest export market for UK. The US and German economies also showed signs of improvement, which helped UK in the running of its export business. Apart from this, ECB never came up with an aggressive monitory easing plan. At the moment, the ECB is increasing liquidity by buying bonds. This has cause the British Pound to increase in value, very slightly. (Hamiton S. 2012) (Milas & Martin, 2009)

London Olympics: In 2012, UK hosted Olympic and Paralympic Games, these events gave a boost to service industry which accounted for ~75% of GDP. With the influx of tourism and money being spent within the UK borders, this caused an increase in supply and demand within a specific area. With the money brought in now part of the British economy, it begins to flow around the economy, raising the level of disposable income. (Thompson M 2012)

Measures taken by Bank of England

Quantitative easing: During the periods of March of 2009 to January 2010, and October 2011 to May 2012, the Bank of England purchased assets for £200 billion and £125 billion, respectively, in two phases of quantitative easing, designed to positively impact the economy. (Michael A. & S. Joyce, 2012)

With enough bank balances, these financial institutions then showed enthusiasm to lend money to companies and individuals, even though the regulations against risky lending to those with subpar credit ratings did not change very much. This made interest rates to fall and thus, consumer spending boosted. (Michael, 2012)

Monetary Policy Committee: Bank of England has announced Monetary Policy Committee (MPC) that will keep interest rates on hold and the size of the asset purchase facility unchanged. This will impact the UK economy by determining at what level banks will be willing to lend money to entities that might not be optimal risk. Such a move would indicate confidence in the borrower ability to repay the loan, which in turn signifies a confidence in the economy, crucial to recovery.

Funding for Lending Scheme: In July 2012, UK got another monetary boost from Bank of England in the form of Funding for Lending Scheme (FLS). The FLS is designed to incentivise banks and building societies to boost their lending to UK households and non-financial companies. The scheme was designed to reduce funding costs for banks and building societies so that they could make loans cheaper and more easily available. That allowed banks to increase lending to UK households and firms, both by lowering interest rates and increasing credit availability. Easier access to cheaper bank borrowing boosted spending in the economy like, people started to buy homes. (Richards S. 2013)

The Mundell-Fleming model

The Mundell-Fleming model is an economic model which portrays the relationship between the nominal exchange rates and a country’s output. It offers a framework for economic analysis in the relationship between the exchange rate, interest rate and output of an economy. According to this model, an economy cannot sustain a free capital movement, a fixed exchange rate and an independent monetary policy concurrently. Frequently called the "impossible trinity," it argues that an economy cannot sustain itself indefinitely on these three concepts without intervention. In terms of how this affects the UK economy, it offers justification for attempts at regulating any of these three factors to ensure the model does not apply and the economy does remain stable, usually by legislating monetary policy, which is the easiest route. (Intermediate Macroeconomics 2012-13)

The model can be explained with the help of the following equations:

IS component: Y = C + I + G + NX

Where

Y: GDP

C: Consumption = C(Y - T,i - E(p))

T: Taxes

I: Interest Rate

E(p): Expected inflation rate

I: Investment = I(i - E(p),Y - 1)

Y - 1 : previous period GDP

NX: Net exports = NX(e,Y,Y * )

e : Real exchange rate

Y * : GDP of the foreign country

LM component: M/P=L(i,Y)

Where

M: money supply

P: average price

L: liquidity

BP component: CA+KA

Where

CA: Current account surplus

KA: Capital account surplus = z(i - i * ) + k

z: capital mobility

i *: foreign interest rate

k: exogenous component of financial capital flows

(EconomyWatch 2010)

Exhibit 1: Flexible Exchange Rates and Extensions

The UK has flexible exchange rates policy so it falls under the economies having "independent monetary policy" and "free capital movement". The model shows:

IS curve: Output = Consumption + Investment + Government Spending + Net Exports

LM curve: Money supply/Price = Liquidity preference (Interest rates, Output)

BP curve (Balance of Payments curve): Current accounts (Net Exports) + Capital accounts (Cash Flow)

Since the country has flexible exchange rates, this means the Bank of England allows exchange rates to be set exclusively by prevailing market forces. At the same time, this provides flexibility to the central bank to increase the money supply to stimulate the economy. Any increase in people’s wages causes higher spending thus, improving the imports. Higher imports over exports depreciate the GBP (Pound) to the extent which it is enough to hold UK’s net exports constant. (Carlin & Soskice, 1990)

This economic change makes the LM curve to move to the right. Depreciation in Pound makes local supplies attractive, consequently, net export increases. Increase in net exports moves the IS curve to the right to the level where the balance of payment is the same. It also means that at this point, domestic interest rate become equivalent to global interest rates.

Given that the model is for open economy, while everything comes to normal, the GDP starts growing up. This clearly means that any increase in money supply does not have a long term effect on the interest rates. The Bank of England raised the supply of money through quantitative easing to boost the economy. But this could have resulted in depreciated value of Pound, lower living standard and a risk of hyperinflation.

Another scenario with flexible exchange rates can be when government spending goes up. This makes the IS curve to move to the right. Higher government spending results in improvement in GDP and increases domestic interest rates as compared to the global interest rates. In this case, value of Pound appreciates which attracts foreign imports and, as a result, net exports decreases. Again, the IS curve moves back to its original place where both the domestic and international interest rates are equal. This brings in no change on the LM curve.

This model shows that if there is "perfect capital mobility" in the economy, the increase or decrease in the government expenditures have no significant impact on the GDP. (Prior K. 2013) (Carlin & Soskice, 1990)

Proposed steps that can be taken by the Government and Bank of England

A credible fiscal consolidation plan: The country needs a courageous and appropriate plan that will signal the commitment to provide the necessary degree of fiscal consolidation over the coming years to bring public finances to a sustainable path, while still supporting the recovery, such as heavier penalties for predatory lending on the part of banks, and more accountability for those who mismanage funds in higher financial institutions. It would also mean a potential streamlining of financial legislation processes. (Carlin & Soskice, 1990)

Strategy to deal with the structural problems: The existing lower productivity among the industries is a result of incompetent utilization of resources and slow implementation of structural reforms. Education and healthcare sectors are among the badly impacted sectors. The government should come up with institutional to foster the industries so that innovation can be encouraged and resources can be optimally utilized. Government should also create efficient labour reforms so that employment, re-employment and fair wages can be promoted. The reforms should be sufficiently funded, perhaps by a fixed tax on little changing areas, such as property tax, so that temporary joblessness could not be converted into long term unemployment. (OECD 2010)

Increase ability to tap new sources of growth: Innovation strengthens competitiveness, as developers look for new answers to existing problems in advance of their competition. Although the UK is a very innovative society, especially in the field of social responsibility to its citizens through healthcare and education, much can still be done to boost the positive spill overs from its knowledge base to productivity, including better efforts at commercialisation of innovation. The UK could also do more to realign economic and environmental objectives by overhauling current policy that is ineffective, due to statistical data over the last decade for verification, and to unleash the opportunities for green investment, including more efficient use of green tax instruments. Green taxes contribute well to the economy by taxing such things as pollution produced by industry, taxes on emissions, and higher taxes on fuels. It supplies a source of revenue, while encouraging industry to move away from polluting practices and seek cleaner alternatives, for the goal of avoiding having to pay such a tax. (OECD 2010)

Variable mortgage rate: An increased use of long term fixed mortgage rates could dampen the impact of interest rate change on household disposable incomes. However, variable rate mortgages have helped cushion household incomes in the recession as rates dropped. Continued vigilance is also needed on the regulation of new mortgage lending, particularly given the risks of highly geared households falling into negative equity if house prices fall significantly at any point or becoming unable to service their debts if interest rates rise. The UK has an independent monetary policy which theoretically permits the monetary authority to influence the interest payments-to-income ratios of households, and thereby their solvency. This is especially true given that the majority of mortgage loans in the UK are based on a variable-rate schedule. However, given the Bank of England's inflation target mandate, discretionary use of monetary policy instruments is largely limited.

Financial transaction taxes: A system of modest financial transaction taxes (FTT) on financial transactions can be a solution. Financial transaction taxes are levies placed on a certain type of monetary transaction for a dedicated purpose, such as the trading of securities. Imposing such a tax on securities transactions tend to decrease volatility and stabilize the industry. In return, it is hoped for that this would help stabilize the UK economy. FTT will shrink the transactions of stocks, options, futures, credit swaps and at the same time, can raise revenues to government, which would help to offset the debt incurred by governments as a result of this crisis. (Carlin & Soskice, 1990)

Conclusion

At present, the key challenges to the UK economy are recovering from recession, boosting employment, avoiding long-term unemployment situation, generating growth potentials, avoiding possibility of a triple-dip recession and minimizing social disparity.

The Bank of England and government should continue their monetary stimulus initiatives such as quantitative easing and other funding programs to sustain the economy. Monetary policy is the primary tool to support the economy in the short term. Fiscal framework, structural reforms and earned policy credibility can boost the economic growth.

To shield the taxpayer and the domestic economy from failures in the financial sector, the proposals from the independent commission on banking should be implemented. The UK government should pursue structural reforms for enhancing the growth and for reducing the inequality. Labour market and social policies should reduce this risk. These approaches will help UK to achieve gradually improving growth in 2013. (OECD Undated)