U0B No_ 09030275
a) The Bank of England is the central bank of the United Kingdom and Central Bank and controls the financial intermediation process. The prime function of a central bank is to manage the nation's money supply, also known as the monetary policy. Central banks achieve this by managing a state’s currency, supply of money and the interest rates. Central banks usually print the national currency and can increase the amount of money. Interest rates can be adjusted accordingly in order to promote economic growth and stability. The tools used by central banks are all used under the implementation of the monetary policy. Central banks can also lend money to the banking sector if there is a financial crisis and banks run out of money. A financial crisis can happen and previously has, in 2008. The government of the United Kingdom acquired stakes in three banks and effectively had to bail them out. Lloyds TSB, HBOS and the Royal Bank of Scotland (RBS) were acquired. Up to 43.5% was bought of Lloyds and HBOS and a massive 81.14% of RBS.
Most of the money owned by people is within bank accounts. However banks don’t keep all of the money deposited into bank accounts physically in the bank. The process of credit creation is used. This is when existing deposits are turned into credit facilities for borrowers. This increases money supply, one of the primary aims of the central bank. For example, if all the bank accounts of a particular bank contain £1billion in total, this doesn’t necessarily mean all the branches of the bank will hold a total of £1billion. All the branches will hold some money but most of it will be in circulation through lending. This could be any ratio but around 10-20% will be kept with around 80% being lent out. To avoid a financial crisis, all depositors mustn’t want all their money back at the same time as banks don’t hold that much money.
Central banks also use expansionary policy to attain low unemployment in a recession by lowering interest rates. This is done in the hope that businesses expand.
Contractionary policy is used so there is a fall in output and prices and to alleviate inflationary pressure. The main macroeconomic objectives are to attain:-
High and stable economic growth
Low and stable inflation
Balance of payments equilibrium
b) The fiscal multiplier measures the change in output following a change in autonomous expenditure (the essential or basic amount of consumption plus investment. Small changes in the autonomous expenditure can generate big changes in national income. For example, if the fiscal multiplier equates to 1, a £1 increase in taxation will reduce the GDP by £1. If the government pumps money into the system and increases their spending, especially during the times of recession, then more jobs will be created and there will be changes in national income. An increase in fiscal spending can lead to an increase in consumption. However, this can be risky and backfire.
Multiplier = 1/MPS = 1/(1-MPC)
This version of the multiplier is most commonly used but once you add taxes into the equation, it completely changes. The taxes (like savings) are part of income that leak out and never become expenditure. So, the new formula of multiplier becomes:-
Multiplier = 1/ (1-MPC + t) = 1/(MPS + t)
T = taxes
The IMF mistakenly reported the fiscal multiplier was around 0.5. This meant that a £1 reduction in government spending would reduce the GDP by £0.50. The actual multiplier turned out to be near the 1.7 mark, underestimated by more than 1. The higher the multiplier, the harder it is to reduce the deficit amount in which the government spends more than it receives in taxation (deficit reduction). The mistake means in essence that the deific reduction is taking a lot more out of output than what the IMF originally reported. For the UK, this has serious implications. Underestimating the fiscal multiplier at 0.5