The Bank of England's new firepower was quantitative easing . In this first stage of the crisis consumers also felt a price squeeze: commodity prices rose rapidly in 2007 and the first six months of 2008. In the UK. i. the government has taken significant steps to strengthen the framework of fiscal policy and achieve macro economic objectives viz. Keynes argued that saving and investment are not the . wage cuts could make matters much worse. food and other basic costs. and if saving does not immediately fall in step. doing so would reduce consumer demand. depressions. perhaps due to falling consumer demand. pushing up petrol. the bank rate was slashed from 5% in October 2008 to 0.Impact of Keynesian economics on modern economic and political theory. In the current political and economic scenario. It wasn't enough to ward off recession. That made institutions more likely to buy other assets such as corporate bonds (that makes it cheaper for companies to borrow on bond markets) and shares in the form of rights issues (that makes it cheaper for companies to raise money on equity markets). He also argued that to boost employment. It all combined to makes companies feel richer and less likely to sack workers. sustained economic growth. less likely. low inflation/stable prices. This was the beginning of the credit crunch. so that the aggregate demand for goods would drop. low unemployment. Problems with the repayment of sub prime mortgages in the US triggered a tidal wave of concern about lending around the world in August 2007. real wages had to go down: nominal wages would have to fall more than prices. or pessimistic business expectations.5% by March 2009.e. by which the government would use fiscal and monetary measures to aim to mitigate the adverse effects of economic recessions.increasing the supply of money in the UK economy. the economy would decline. This would in turn reduce business sales revenues and expected profits. Keynes theory argued that the interaction of aggregate demand and aggregate supply determines the level of output and employment in the economy. Excessive saving results if investment falls. Instead of raising business expectations. This surging inflation prevented central banks from cutting interest rates to help ease the credit crunch. British house prices began falling soon after and only stabilized in April onwards of2009. was a serious problem. excessive saving. encouraging recession or even depression. The Bank created money and bought assets (gilts) from financial companies. which can be measured with Libor. saving beyond planned investment. over-investment in earlier years. However. and booms. driven by demand from booming China and India. Investment in new plants and equipment—perhaps already discouraged by previous excesses—would then become more risky. Northern Rock ran into trouble in September 2007 and was finally nationalized in February 2008. He is particularly remembered for advocating interventionist government policy. To Keynes. and environment. The initial reaction was for central banks to slash rates. balance of payments between imports and exports. Keynesian economics had a major impact on modern economic and political theory as well as on many governments’ fiscal policies since 1933.

because "in the long run. In sum. because of fear of capital losses on assets besides money. The strength of Keynesianism's influence can be seen by the wave of economists which began in the late 1940s with Milton Friedman. while New Keynesian economics have sought to base Keynes's idea on more rigorous theoretical foundations. that is policies which acted against the tide of the business cycle: deficit spending when a nation's economy suffers from recession or when recovery is long-delayed and unemployment is persistently high—and the suppression of inflation in boom times by either increasing taxes or cutting back on government outlays. An example of a countercyclical policy is raising taxes to cool the economy and to prevent inflation when there is abundant demand-side growth. Keynes suggested that there may be a "liquidity trap" setting a floor under which interest rates cannot fall. Rather than seeing unbalanced government budgets as wrong. in the 1960s. Keynes advocated what has been called countercyclical fiscal policies. Instead. This problem was referred to as the need for “microfoundations for macroeconomics”. interest rates are so low that any increase in money supply will cause bondholders to sell their bonds to attain money (liquidity). While in this trap. He argued that governments should solve problems in the short run rather than waiting for market forces to do it in the long run. Rather than prices adjusting to attain equilibrium. the supply of and the demand for the stock of money determine interest rates in the short run. Keynes′ theory suggested that active government policy could be effective in managing the economy. Supply can be analyzed either from the microeconomic level of a small firm supplying a particular product or to the . criticized Keynesian theories. Finally. as unemployment in labor markets encourages excessive saving—and vice-versa. Instead of rejecting macro-measurements and macro-models of the economy. especially in the short run. we are all dead. the main story is one of quantity adjustment allowing recessions and possible attainment of underemployment equilibrium. which began in the late 1960s and early 1970s. to Keynes there is interaction between excess supplies in different markets." Keynesianism recommends counter-cyclical policies to smooth out fluctuations in the business cycle. it was widely agreed that the apparent inconsistency between the structure of macroeconomic models and the kind of economic theory used in other branches of applied economics posed a fundamental challenge to the coherence of modern economics. Factors influencing supply of product One of the fundamental concepts of a market economy is the supply of goods necessary to satisfy consumer demand. and engaging in deficit spending on labor-intensive infrastructure projects to stimulate employment and stabilize wages during economic downturns. By the time that Keynesian macroeconomics had reached full maturity. The New classical macroeconomics movement. they embraced the techniques of treating the entire economy as having a supply and demand equilibrium.main determinants of interest rates.

Technology relates to methods of transforming inputs into outputs. thereby raising the overall level of aggregate demand (assuming aggregate supply cannot keep up with . 2.macroeconomic level of many firms supplying those products as a whole. which raises the price of imports and.If firms expect prices to rise in the future. Decrease in the aggregate supply of goods and services. The major factor that influences supply is the "cost of production". Improvements in technology will reduce the costs of production and make sales more profitable so it tends to increase the supply. reduces the price of exports. may try to product less now and more later. will comprise of the supply schedules of all the firms in that industry. 3. and less will be produced. thus pulling up prices. the purchasing of imports decreases while the buying of exports by foreigners increases. An industry's supply in this case. Decrease in the demand for money. an increase in government purchases can increase aggregate demand. and includes: 1. As a result. This leads to a decrease in supply. Relationship between inflation and aggregate demand Increase in the money supply. The increase in aggregate demand (AD) that causes demand-pull inflation can be the result of various economic dynamics. Another factor can be the depreciation of local exchange rates. for foreigners. Technology . and capital increase. Expectations . raw materials. Increase in the aggregate demand for goods and services are factors leading to inflation. Input prices . The AD curve shows the relationship between the general price level and real GDP. For example. production tends to be less profitable.As the prices of inputs such as labour.

An increase in transfer payments raises AD – particularly if welfare recipients spend a high % of the benefits they receive. which attempts to stabilize the economy by controlling interest rates and the money supply. lower rates of income tax raise disposable income and should boost consumption. The results of reduced taxes can lead also to growing consumer confidence in the local economy.this directly increasesAD. which further increases aggregate demand. Fiscal policy can be contrasted with the other main type of macroeconomic policy. In economics. A rise in house prices or the value of shares increases consumers’ wealth and allow an increase in borrowing to finance consumption increasing AD.a short term boost to AD. expected increases in consumer incomes. Similarly. In contrast. For example. monetary policy. . households are left with more disposable income in their pockets. meaning that a large and rising share of our national output is linked to exports of goods and services or is open to competition from imports. fiscal policy is the use of government expenditure and revenue collection to influence the economy. This in turn leads to increased consumer spending. An increase in overseas incomes raises demand for exports and therefore UK AD rises.aggregate demand as a result of full employment in the economy). Changes in the level and composition of taxation and government spending can impact on the following variables in the economy: • • Aggregate demand and the level of economic activity. . thus increasing aggregate demand and eventually causing demand-pull inflation. Income tax affects disposable income e. Changes in Fiscal Policy also plays an important factor. wealth or company profits encourage households and firms to spend more – boosting AD. A fall in the value of the pound (£) (a depreciation) makes imports dearer and exports cheaper thereby discouraging imports and encouraging exports – the net result should be that UK AD rises – the impact depends on the price elasticity of demand for imports and exports and also the elasticity of supply of UK exporters in response to an exchange rate depreciation. In contrast a recession in a major export market will lead to a fall in UK exports and an inward shift of aggregate demand.g. Finally. If interest rates fall – this lowers the cost of borrowing and the incentive to save. The UK is an open economy. higher expected inflation encourages spending now before price increases come into effect . The two main instruments of fiscal policy are government expenditure and taxation. Lower interest rates encourage firms to borrow and invest. The expectations of consumers and businesses can have a powerful effect on planned spending in the economy E. a fall in the value of share prices will lead to a decline in household financial wealth and a fall in consumer demand.g. An expansionary monetary policy will cause an outward shift of the AD curve. the Government may increase its expenditure e. if government reduces taxes. The pattern of resource allocation. thereby encouraging consumption. financed by a higher budget deficit.g.

In the past year there have been a lot of measures taken to try to get the UK economy up and running again following the global economic crisis. • • A contractionary fiscal policy occurs when government spending is lower than tax revenue. However as soon as the banking crisis occurred due to the banks over lending too freely. The simplest definitions of these stances are as follows: A neutral stance of fiscal policy implies a balanced economy. Unable to get wholesale funding UK bank Northern Rock was forced to turn to the Bank of England as lender of last resort in September 2007. The three possible stances of fiscal policy are neutral. The UK experienced a double bubble in both housing and the stock markets from 2001 2007. altering the deficit situation. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity. these are not considered to be policy changes. for purposes of the above definitions. • An expansionary stance of fiscal policy involves government spending exceeding tax revenue. a government budget that is balanced over the course of the business cycle is considered to represent a neutral fiscal policy stance. expansionary and contractionary. Thus. Fiscal Policy Fiscal policy refers to the use of the government budget to influence the first of these: economic activity. Therefore. even with no changes in spending or tax laws at all. “government spending” and “tax revenue” are normally replaced by “cyclically adjusted government spending” and “cyclically adjusted tax revenue”. for example.Credit was cheap and easy. regulation lax and rules broken.• The distribution of income. Home prices peaked in the third quarter of 2007 and the long decline set in. house prices tripled in some areas during that period and the London Stock Exchange (LSE) reached record highs. This is due to the economy growing at a fairly steady rate and there wasn’t much need for government intervention in regards to increasing spending as consumer spending was fairly high due to consumer confidence in the market. Before the financial crisis fiscal policies were seen as quite traditional old fashioned policies. these definitions can be misleading because. This led to the first run on a British bank in . However. this results in a large tax revenue. cyclical fluctuations of the economy cause cyclical fluctuations of tax revenues and of some types of government spending. Fuelled by mortgages of up to 125 per cent. many people found it difficult to obtain loans and as a consequence consumer spending became at one of its lowest since the last crisis 35 years ago .

Household names in the High St including Woolworths.5% (plus or minus 1%). One of Gordon Brown’s first acts as Chancellor of the Exchequer in 1997 was to give the BoE independence in setting rates. and relatively stronger groups like Barclays. On no . UK Monetary Policy is set by the Bank of England. It was nationalised after the end of World War II. The Bank of England's record since it was made independent in May 1997 has been a strong one. and plays a key role in monetary policy. which also took over government cash management in 2000. with the decision to grant the Bank operational independence. Computer share took over as the registrar for UK Government bonds (known as gilts) from the Bank at the end of 2004. help Alliance & Leicester and HBOS get bought. and forced the government eventually to nationalise the bank. The Bank of England had cut interest rates to 1. Northern Rock did not mark the end of the British government’s involvement in the financial sector. Adams and Waterfords Wedgewood went into receivership by Christmas 2008.0 per cent by the end of 2008.the Government sets the inflation target within which the Bank must operate when carrying out monetary policy decisions. With consumer confidence dropping and unemployment rising.generations. which previously had to be approved by the Chancellor. and became known as the ‘Old Lady’. HSBC and Standard Chartered. responsibility for government debt management was transferred to the new UK Debt Management Office in 1998. It was established in 1694 under the Bank of England.5 per cent for most of 2009 and 2010. By Q2 2008 the UK was officially in recession and Sterling had dropped more than 30 per cent against the other main currencies. where it is located in London. MFI. managing the national reserves and helping to maintain the stability of the British bankingand financial systems. It should be remembered that the government retains control of the final objective of monetary policy .. However. Underlying inflation has stayed remarkably close to the official target measure of 2. Since 1997 the Monetary Policy Committee (MPC) has had the responsibility for setting the official interest rate. the auto and retail sector were the next victims of recession. It was forced to nationalise Bradford & Bingley. and provide capital. or the Old Lady of Threadneedle Street. Impact of lowering Interest rate in influencing economic activity The Bank of England or BoE is one of the oldest central banks in the world. and that is expected to drop to 0. funding and underwriting worth more than 400 billion GBP to both over-leveraged giants like RBS and Lloyds TSB. Zavvi (the former Virgin Megastores).

the UK economy moved out of the recession. while stronger growth of 1. with GDP increasing by 0. following a 0.2 per cent of GDP.7 billion of imports (6th in the world). which excludes energy production. A recent study from the National Institute of Economic and Social Research (NIESR) claimed that had the Bank kept interest rates at 6% during the first two and a half years of its life as an independent bank.6% recorded in the previous three months. reaching close to 2 million unemployed. In the last quarter of 2009.8 per cent in 2010.3 per cent in the UK by the end of 2008 according to the Office of National Statistics. With economic stimulus packages and bank bailouts being worked on. This figure could rise to 58. Giving the Bank a degree of independence is no guarantee of macro-economic stability in the long run. rose by 1. but has dropped back with the economic collapse and was expected to be 0. The 3-month Treasury rate has similarly dropped. from 5.3 per cent of GDP in 2008.occasions has the Governor of the Bank of England been required to write an open letter to the Chancellor explaining either an inflation over-shoot or an under-shoot. the final outcome in terms of output and inflation would been broadly similar from the actual out-turn.5% in the latest quarter. It runs $468.4 per cent in 2009 and 0.2% increase in the first quarter of 2010. This was followed by a more moderate 0. Inflation had ramped up to 3. It had the 58th lowest inflation rate in the world at end 2008. This figure is likely to grow to the 2. The unemployment rate had reached 6. Total production output increased by 0.5 per cent in 2008 to an expected 1. UK budget deficit stood at 5.2% was recorded in the second quarter.1% in quarter three of 2010. Manufacturing output. meaning that the rules have gone out of the window as fighting the recession takes priority. that was expected to balloon to 11. The UK has the third highest current account deficit in the world of US$186 billion. thanks to the projected budget deficits of 2009-2010.7 billion of exports (9th in the world export rankings) and $654. the UK had the 43rd largest relative national public debt.3 per cent of GDP in 2009 and 13 per cent of GDP in 2010. at 47. In 2008. .6 per cent in 2008. Keynesian economics says this is the right thing to do. or 8-10 per cent. and could rise to 70 per cent of GDP by 2010. although GDP was 2.5% in the third quarter of 2010. but it leaves the British government finances dangerously over leveraged . compared with a stronger increase of 1. compared with growth of 1% in the previous quarter.4%. In the third quarter growth slowed again slightly to 0. By the end of 2008 estimated public debt had already risen to 42 per cent. after all.5 million – 3 million figures.6% increase in the previous quarter.5 per cent of GDP by 2009 and 70 per cent of GDP in 2010. what got us into this mess in the first place.and over leverage was.7% higher than in quarter three 2009. It has a large trade deficit in manufacturing and has become a net importer of energy and North Sea extraction declines. Output in the service industries rose by 0.3 per cent in 2009 and 2010.7%.

This is largely due to lower employment levels in the public sector. equivalent to 71. The number of people in employment was 29. The Bank of England expects UK inflation to remain above the 2% over the coming months. The number of unemployed people rose by 35 000 over the quarter to reach 2. Latest data for November 2010 indicates that annual inflation was 3. followed by growth of 2.1% in 2011. which has direct control over the economic forecast and makes all the key judgments that drive the official projections. The employment rate for people of working age was 70. down by 33 000 compared with the previous quarter. The UK budget deficit rose sharply in 2008/09 and 2009/10. the UK economy is projected to expand by 1.3% of GDP. the new government had already announced that it will cut public spending by £6 billion this financial year.1% from the previous quarter. which is committed to start cutting public spending in the current financial year. in the Spending Review. whereas a Labour government would have waited until 2011/12 to introduce spending cuts. in 2009/10 the UK recorded general government net borrowing of £159. borrowing plans were revised by the Labour government in the 2009 Budget. In light of the deteriorating economic conditions. slightly up by 0.13 million in the three months ending October 2010. Furthermore.9%. representing the biggest UK spending cuts for decades. The unemployment rate in the quarter to October 2010 was 7.4 billion.3%.6% and 2. The borrowing plans were revised in the new coalition government’s emergency budget in June 2010. up from £95 billion in 2008/09.8 billion. in a bid to kickstart the economy and to prevent an even more severe economic downturn. down 0. Prior to the June 2010 Budget.6% for the three months ending October 2010.The new Conservative-Liberal Democrat coalition government established the Office for Budget Responsibility(OBR).8% in 2010. Furthermore. Forecasts for GDP by independent analysts average around 1.5% of GDP in 2009/10.1% over the quarter. representing a record high. up from 3. Furthermore. the Labour government announced in the 2009 Budget that it was to bring forward £3 billion capital spending from 2010/11. equivalent to 11. it was announced that a total of £81 billion is set to be cut from public spending over the next four years. The current budget deficit reached 3. in line with government forecasts. According to latest government figures. Slightly stronger annual growth levels of between 2.4% of GDP. published in October 2010.2% in October and remaining above the Government’s 2% target.8% for 2010 and 2% for 2011. as the Labour government increased public borrowing and spending strongly. . at the end of March 2010 general government debt was £1000.5 million.9% are predicted for the following four years. According to the latest Economic and Fiscal Outlook by the OBR. with the government increasing planned public sector net borrowing levels.5% of GDP in 2008/09 and rose to an estimated 7. This is the first quarterly decline in employment rate since the three months to April 2010. with the rise in VAT in January 2011 likely to further drive inflation upwards.

5% in March 2009. representing a new all-time low. reducing the base rate significantly from 5%. The rate cut in March reflects an attempt to boost the shrinking economy and encourage bank lending. and the rates are expected to remain low for the foreseeable future. which so far has not increased despite significant cuts in the base rate in recent months.5%.The latest interest rate cut by the Bank of England took the base rate to 0. . The rate cut in March 2009. The Bank of England has since maintained the base rate at 0. followed five rate cuts since October 2008. as the economic recovery remains fragile.

Princeton University. 17 May 2007. Economywatch n. <http://www. <http://tutor2u. ‘United Kingdom economic forecast’ . ‘ What is fiscal policy?’ viewed 6 February 2011. Knowledge-transfers. n.d. Investopedia. viewed January 2011. Tutor2u. danpite 2010.. <http://www. Moneyweek.aspx>. Heakal. .edu.>. < http://www. UK Macroeconomic activity.asp> AS Macroeconomics/ International ‘Revolution and Evolution in Twentieth-Century Macroeconomics’. Woodford. n.pdf>. Stepek.unisa. <http://www. Reem.. ‘ Fiscal Policy’ . viewed 6 February 2011. viewed 6 February 2011.d. viewed 6 February 2011. Michael 1999.htm>.References Market and Business development 2011.moneyweek. ‘Has independence changed the Bank of England?’.investopedia. independence of the bank of England. Tutor2u. <>.com/news-and-charts/economics/ John 2007.html> viewed on 3 january 2011. < http://www.columbia.html>. <http://www.

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