Demand management

Critically analyse the view that monetary policy is superior to fiscal policy as a form of macroeconomic demand management. (UK Economy)

Governments across the globe strive for achieving a set of macroeconomic level economic objectives, in which to create a stable platform of economic prosperity. Such objectives consist of; high and stable economic growth; low unemployment; low inflation and, the prevention of balance of payments deficits and excessive exchange rate fluctuations

Demand management policies aim to create a stable platform for growth in aggregate demand (AD), whereby to achieve the four macroeconomic objectives mentioned above. The Government uses monetary and fiscal policies in order to achieve these aims. Monetary policy aims to pursue the Government's policy objectives via monetary instruments such as the control of the money supply and interest rates. Fiscal policy on the other hand uses the fiscal instruments of taxation, government spending and the government's budgetary position. Demand management has only recently come into existence with the help of John Maynard Keynes. The period known as the Keynesian era began just after 1945, whereby the UK Government became involved in controlling the state of the economy via demand management policies. The period before this, the Government rarely intervened in markets, thus allowing the market mechanism to ‘sort itself out'. Economists at this time, known as neo-classical economists believed that competitive markets in the long run will automatically adjust toward full employment fuelling economic growth; greatly supportive of free trade. French economist, Jean-Baptiste Say; “believed that free-market capitalism would provide both short-term and long-term prosperity”, (MyEconLab, Profiles of famous economists).

Management of aggregate demand prevents large fluctuations in the business cycle, and ensures that actual growth in real GDP is kept in line with the long-term trend rate of growth. As a result fiscal or monetary policy can help to prevent a booming economy from over-heating, or a recession being too depressed. During the Keynesian era from the year 1945 to 1970 fiscal policy was initially used to manage aggregate demand. A counter-cyclical policy approach was initiated by the Government. In times of a recession the Government would run a budget deficit, whereby to increase public expenditure. Government expenditure, being an element of aggregate demand, in essence provides an injection into the economy. This is publicised as a reflationary fiscal stance. On the other hand in order to prevent an overheating economy growing unsustainably, the Government uses a deflationary fiscal policy. Such a policy may consist of a reduction in Government expenditure and increases in taxes. Monetary policy aided by its own tools can also be an effective method of demand management. Changes in the rate of interest (decided upon by the Monetary Policy Committee of the Bank of England) can influence the direction of aggregate demand, via its effect on consumer borrowing (leading to consumer spending) and business investment. A reduction in interest rates will provide cheaper credit to consumers, as well as providing an incentive for firms to undertake large and risky investment projects.

Both instruments of demand management (fiscal & monetary policy) are effective in their own rights; however the use of an instrument can pose a few problems. One of the Government's instruments of fiscal policy is through the use of automatic stabilisers. The Government's budgetary position automatically changes in accordance with where the economy is at on the business cycle. If for example the economy enters a recession, payments of unemployment benefits automatically increase, whereas tax receipts fall, leading to a budget deficit. The reverse is true for an overheating economy, leading to a budget surplus or a reduction in the budget deficit. Automatic stabilisers can successfully create the conditions to reduce fluctuations in the business cycle by up to 20%. However, discretionary fiscal policy is essential to reinforce the objective of sustainability of economic growth.

Fiscal policy left to its own devices can create a trade-off between two macroeconomic objectives, such as unemployment and inflation. Running a budget deficit, as is what the Government are doing at present, is a good idea in order to recover from the ‘credit crunch'. The effect, to increase public expenditure on public and merit goods, will in theory increase public sector jobs, which in turn will initiate an income multiplier. This is one of the Obama Administration's and Gordon Brown's objectives, following in the line of J.M.Keynes. Gordon Brown's ‘Golden Rule' is an effective instrument to boost demand. The Government will only borrow in order to finance capital expenditure and not current expenditure. Even so, consistent budget deficits will cause an increase in the public sector net cash requirement, and eventually an enlargement of national accumulated debt. Current statistics stand at £11.5bn public sector deficit and £870bn public sector net debt (61.7% of GDP), (Office for National Statistics).

In order to finance this debt the Government must borrow, either from the banking sector in the UK, or from abroad. The Government thus borrows by selling bonds (gilts). This debt sold, if to the banking sector, creates bank deposits. Bank deposits being classed as money, therefore causes an increase in the money supply. According to the theory proposed by Milton Friedman; the Quantity Theory of Money, and the Equation of Exchange (MV=PT) proposed by Irving Fisher causes an increase in inflation, (Milton Friedman, The Optimum Quantity of Money. 2005). Besides the problem of inflation, Government borrowing can lead to crowding out of private sector investments. To facilitate the selling of Government bonds, the Government must first persuade buyers to take on this debt. To achieve this, the Government must raise interest rates on the gilts they sell.

Albeit Gordon Brown being very optimistic about his fiscal stimulus approach, the Chancellor of the Exchequer, Alistair Darling has expressed concerns that the budget deficit must now be greatly reduced. In his Pre-Budget report 2010, Alistair Darling has taken a ‘brave' approach and decided to raise taxes in some areas. The 13 month period of the VAT cut to 15% that ended on 1st January 2010, has hardly made any significant impact on the economy; just an increase in growth of around 0.5%, compared with negative growth of 5.1% in real GDP. Critics claim that this is good; nevertheless I believe that the costs of such a policy may have outweighed the benefits.

The cost of such a stance has cost the Government almost £12bn. Firms are also in a similar situation, costing them a total of £100m on administrative costs (changes in their financial statements), and menu costs (cost of advertising the changes in prices, and cataloguing these changes), (Hickman, M. O'Grady, S. (2010) ‘Retailers count the cost as VAT returns to 17.5%', The Independent, 1 January). VAT, an indirect tax, promotes itself as a regressive tax, which can pose a problem. As consumers on lower incomes pay a higher proportion of their income on indirect taxes (e.g. VAT) on the goods that they purchase, it can widen the gap between the poor and the rich, promoting greater inequality. The Government, keen to increase receipts, has some ‘tricks up its sleeve', via the introduction of stealth taxes. As a keen member of the public expressed his findings in The Times;

The start of the New Year brings forth the first stealth tax. How convenient that the Government, while reinstating the 17.5% VAT rate, has “forgotten” to remove the additional excise duty placed upon petrol and diesel, when the VAT rate was reduced to 15%; (Parmenter, R. (2010) ‘Latest Stealth Tax', The Times, 4 January, p. 25).

Pursuing the aim of reducing the budget deficit, Alistair Darling, in his Pre-Budget Report implemented a “50% levy on all bonuses in excess of £25,000 paid to bankers”, (Deloitte, (2009). Deloitte's Full Pre-Budget Report Commentary). The Chancellor, though, may have overestimated his £550m additional revenue as a consequence of this levy, as bankers and banks plan to relocate to safe-guard their income and profits. The chancellor may have, in effect initiated a contraction in the UK's comparative advantage as a global financial centre. JP Morgan may withdraw their $1.5bn investment in their new headquarters from Canary Wharf, (Aldrick, P. Sibun, J. (2009) ‘JP Morgan may scrap £1.5bn London HQ plan over Labour's attacks on City', Telegraph, 28 December).

In essence, an increase in taxation is likely to increase Government receipts, as we are all liable to pay. However, tax avoidance (which is legal), is likely to increase, as with tax evasion (which is illegal), which can lead to black economies taking a greater proportion of GDP. Nonetheless, as a form of demand management it defies the logic of recovery. Taxation is a leakage from the circular flow model, and given that the UK has a high marginal propensity to tax, it forms a barrier in the ability to increase the nation's disposable income. One of the major drawbacks is the time lag that is generated through policy changes. The chancellor can only revisit discretionary changes at times of the budget; annually. Even though changes in policy are brought up, there are still substantial time lags through when the changes are slowly digested into the economy. Changes on national income, output and employment via the multiplier process is not immediate, and if timed incorrectly, can worsen the economy. Fiscal policy is therefore more rigid than monetary policy in dealing with changes in demand. On the whole, an increase in taxation is likely to pose problems from an economic viewpoint, yet also damaging from a political viewpoint. Given that the next general election just looms round the corner (estimated election date; 6 May 2010), it gives voters the chance for a second thought for electing for the Labour party. It has been forecast that the Conservatives will win with a total of 361 seats as compared to the Labour party with only 212 seats. In the current climate, such results may not look surprising, (Forecast UK. (2010). Latest Forecast - 15th January 2010).

A key characteristic of interest rates (an instrument of monetary policy), is its greater flexibility than instruments of fiscal policy. Interest rates can be altered on a monthly basis, via decisions made by the MPC during their monthly meetings. As a result, stability in the business cycle can be further reinforced, minimising fluctuations with short term changes in interest rates. However, given its flexibility, resistive forces still exist between changes in interest rates to changes in aggregate demand, which in turn influences the rate of inflation in the economy. This time lag that occurs happens via the transmission mechanism of monetary policy. Changes in output and prices via variations in the interest rates occur through various different channels (each adjusted through different time lags), allowing each adjusted channel to flow to the net change in aggregate demand. Sensitivity to changes in various channels varies across the transmission mechanism, which in turn determines our sensitivity to changes in monetary policy. As a result of the transmission mechanism, the MPC believes that changes in interest rates will maximise the change in aggregate demand after one year and an additional year to changes in inflation. As a consequence, monetary policy is pre-emptive. One of the aims of monetary policy is the control of inflation. Forecasts of inflation two years prior to the MPC meeting are made, which influence present interest rates. This ensures that inflation in the future is kept in line with the target rate. For the past decade the MPC have succeeded with the control of inflation, which has provided a stable growth for aggregate demand, (excluding the current period!).

In the midst of the current recession, the Bank of England has kept interest rates at 0.5%. This is an effective strategy in order to encourage consumer borrowing as well as business investments. The majority of homeowners in the UK have mortgages based on variable rate mortgages. Research shows that at least “100,000 homeowners every month are benefiting from the rock bottom base rate”, (Glitec Finance, (2009). One hundred thousand homeowners a month benefit from low interest rates). Lower interest rates decrease the cost of the mortgage, which as a result provides an increase in the wealth of the household, enabling them to indulge upon mortgage equity withdrawals. For that reason such a stance is a vital stimulant upon aggregate demand, thus implying that households are greatly sensitive to changes in interest rates. The liberalised mortgage market in the UK promotes greater competitiveness among mortgage lenders; as a result lenders are more likely to adjust their interest rates in line with the base rate set by the Bank of England.

A major drawback in the use of monetary policy during a recession is its limited ability of how far low interest rates can go. Taking the rate of interest to be, say, 0% or 0.5% is perfectly fine. However when taking inflation into consideration, real interest rates may in fact be negative (in effect the lender is actually paying the borrower), therefore can pose a significant problem. The Monetary Policy Committee is currently stuck with a real dilemma. The UK economy is currently facing a problem of stagflation, whereby unemployment is high (around 7.8% ILO) and inflation is creeping up (2.9% CPI), (Office for National Statistics). Stagflation was the main setback for the UK economy during the 70's, ending the Keynesian era. Present inflation is racing away from the Government's 2% target, and in the unlikely event, interest rates would have to be raised, which may further lengthen the recovery stage.

Britain, being a major trading partner with Europe, USA, India and China, helps to reel in foreign direct investment (FDI), benefiting our economy via low interest rates. In theory to kick start the accelerator process (via the injection of investment), in turn allowing the multiplier process to initiate. However, the ‘credit crunch' being a global problem, limits the availability of credit in the financial system, thus providing no incentive for large multinational corporations to undergo risky investment projects. Though there is some increase in FDI into the UK, due to low interest rates, foreign investors find it unattractive to hold their money in UK institutions, further tightening credit available to borrowers.

Fiscal and monetary policy may be allocated different policy objectives, or both can be used interdependently to support each other to pursue the same objective, in this case the management of aggregate demand. The use of fiscal or monetary policy independently can pose a few problems as mentioned in the text above. Yes, fiscal policy, via increases in Government expenditure provides an injection into the economy to initiate a multiplier process; but it is essential to analyse if the effects are advantageous as proclaimed in textbook theory. The setback the UK faces is the fact that the income multiplier is quite low. Income generated via successive stages of the multiplier gets smaller than the earlier stage as the UK's marginal propensity to tax and import are both high, both leakages from the circular flow model. If not spent on imports or on taxes, income would be saved in the hope to minimise the effects of going into debt. Financing the national debt is a must, yet spending taxpayers money on refinancing this huge debt implies the opportunity cost of which the funds could have been spent on more productive uses such as on education or to subsidise private investments on renewable energy sources, etc. In essence, fiscal policy is best suited to correcting market failure and improving the supply-side of the economy, by providing incentives for individuals and firms to make the optimal choice, and in addition to improve the provision of public and merit goods. As a result fiscal policy is best suited for managing the micro element of the economy. Monetary policy is more sophisticated in terms of its responsiveness and flexibility to changes in the business cycle. The general public are usually very sceptical about the ideology of fiscal policy, mainly due to the fact that it may be manipulated for political circumstances, especially in times of general elections. The fact that the Bank of England preserves its status as independent, increases the credibility of the policy, where after independence, monetary policy is now implemented by non-political figures. Furthermore, monetary policy successfully promotes high levels of transparency, via the publication of ‘Minutes' from MPC meetings. Though interest changes are effective in managing aggregate demand, where it is limited is its ability to be universal. Some industries are more affected to changes in interest than others; hence changes do not have a uniform impact on the economy. Industries are greatly affected where demand is interest elastic, i.e. firms linked to the housing market. Where both policies fail is the control of confidence among individuals and firms. Confidence in the economy is the main driver of economic growth, and without it there is no hope. In theory what the economy needs in order to manage aggregate demand is to first manage ‘aggregate confidence'. In part, the media can be to blame for diminishing consumer confidence through bold publications. On the whole it seems monetary policy is superior to fiscal policy as a form of macroeconomic demand management; though both policies must support each other to be best efficient in managing aggregate demand.

References

Aldrick, P. Sibun, J. (2009). JP Morgan may scrap £1.5bn London HQ plan over Labour's attacks on City. Available: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/6900501/JP-Morgan-may-scrap-1.5bn-London-HQ-plan-over-Labours-attacks-on-City.html .

Deloitte. (2009). Deloitte's Full Pre-Budget Report Commentary. Available: http://www.ukbudget.co.uk/PreBudget2009/attachments/UK_PBR2009_full_measures.pdf .

Forecast UK. (2010). Latest Forecast - 15th January 2010. Available: http://www.forecastuk.org.uk/

Glitec Finance. (2009). One hundred thousand homeowners a month benefit from low interest rates. Available: http://www.glitec.co.uk/2009/10/one-hundred-thousand-homeowners-a-month-benefit-from-low-interest-rates/ . Published 31/10/2009.

Hickman, M. O'Grady, S. (2010). Retailers count the cost as VAT returns to 17.5%. Available: http://www.independent.co.uk/news/business/news/retailers-count-the-cost-as-vat-returns-to-175-per-cent-1854754.html . Last accessed 01/01/2010.

Milton Friedman (1956), “The Quantity Theory of Money: A Restatement” in Studies in the Quantity Theory of Money, edited by M. Friedman. Reprinted in M. Friedman The Optimum Quantity of Money (2005), pp. 51-67

MyEconLab. (n.d). Thomas Malthus, David Ricardo and Jean-Baptiste Say: How gloomy was classical economics? Available: http://myeconlab.mathxl.com/login_econ.htm?noinit .

National Statistics Online. (2010). Public Sector. Available: http://www.statistics.gov.uk/cci/nugget.asp?id=206 . Published 21/01.2010.

Office for National Statistics. (2010). Latest Indicators. Available: http://www.statistics.gov.uk/instantfigures.asp . Published 27/01/2010.

Parmenter, R. (2010) ‘Latest Stealth Tax', The Times, 4 January, p. 25

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