Keynesians consider fiscal policy as their most important tool of economic management especially when it is used with an accommodating monetary policy. In contrast, monetarists consider monetary policy as all important and fiscal policy must be used to accommodate monetary targets.
If GDP fell in Europe, it would be apparent that either aggregate demand (AD) or aggregate supply (AS) had fallen.
If AD fell the price level would also fall, provided that the previous AD level wasn’t at under-full employment equilibrium. (If it was, a reduction in AD wouldn’t effect inflation (price level) however unemployment would be created).
If we assume that AD wasn’t at either full employment or under-full employment equilibrium, any change in AD would influence a change in both real GDP and inflation.
If GDP fell in Europe it would consequently affect Aggregate Demand in the UK. Firstly we must establish the meaning of GDP. GDP is an acronym for gross domestic product; this is the total value of the output of an economy usually measured over 1 year. AD is made up of 5 components. (1) Consumers' expenditure (C) on goods and services: This includes demand for durables & non-durable goods. (2) Gross Domestic Fixed Capital Formation (I) - i.e. investment spending by companies on capital goods. Investment also includes spending on working capital such as stocks of finished goods and work in progress. (3) General Government Final Consumption (G). i.e. Government spending on publicly provided goods and services including public and merit goods. Transfer payments in the form of social security benefits (pensions, job-seekers allowance etc.) are not included as they are not a payment to a factor of production for output produced. A substantial increase in government spending would be classified as an expansionary fiscal policy. (4) Exports of goods and services (X) - Exports sold overseas are an inflow of demand into the circular flow of income in the economy and add to the demand for UK produced output. When export sales from the UK are healthy, production in exporting industries will increase, adding both to national output and also the incomes of those people who work in these industries. (5) Imports of goods and services (M). Imports are a withdrawal (leakage) from the circular flow of income and spending in the economy. Goods and services come into the economy - but there is a flow of money out of the economic system. Therefore spending on imports is subtracted from the aggregate demand equation.
The aggregate demand equation is thus;
AD = C+I+G+(X-M)
(X-M) is the current account on the balance of payments. It is this part of the equation which is of most importance when answering the question.
AD is likely to fall in the UK as a result of reduced GDP in Europe; a decrease in export demand causing a withdrawal of foreign demand from the domestic economy. I.e. X decreases making (X-M) smaller and thus reduce AD as a whole.
Exports of goods and services (X) fall because the value of the output of the European economy has also fallen and they therefore have less money to spend on UK products.
If AD is reduced it is evident from the diagram (next page) that GDP falls and thus price level also falls.
The European countries will want to boost aggregate demand and may use monetary policy to do this; a reduction in interest rates will encourage spending in these European countries boosting AD as desired but won’t prove as attractive to ‘hot money’. This is money that circulates the globe taking advantage of countries offering favorable rates of interest. The UK may become an asylum to this ‘hot money’, an increased demand for sterling will lead to a strengthening of the pound, and thus a further increase in AD, real GDP and price level.
Most theories of consumption place emphasis on the importance of consumer confidence in determining levels of spending. The willingness and ability of households to their spending can change as the state of the economy alters. For example in an economic slowdown, the fear of rising unemployment may cause confidence to decline. Spending on "big-ticket items" such as a new car or a new kitchen may then fall. Conversely, in a cyclical upswing we expect to see a recovery in consumer sentiment and a greater willingness to go out and commit to higher levels of spending. This was certainly apparent in 1997-98 when spending was fuelled by windfall gains and rising real incomes. Another rebound in confidence is apparent in 1999 early 2000 as the economy picks up from a slowdown in activity. The Bank of England looks closely at the consumer confidence figures when assessing future movements in demand and output. High confidence levels may be used as evidence to raise interest rates to control the growth of household demand. Lots of economic factors affect the overall state of consumer confidence. Some of these factors include: The level of interest rates (including mortgage rates), Changes in unemployment and the state of job security / insecurity, Expectations of inflation, Changes to direct and indirect taxation, and Windfall Gains (for example arising from the stock market floatation of many former building societies).
A rise in UK consumer confidence will cause an increase in consumption thus increasing AD, causing increased inflation and an increase in real GDP. The confidence of consumer in addition wears off on the businesses at which they shop/use. The businesses react to the increased demand by investing themselves this also contributes to an increase in AD, real GDP and inflation. AS will increase in the long run consequently to the investment. An increase in AS will increase real GDP but will reduce inflation. (Diagram PTO) It is for this reason in my opinion that consumer confidence is of such importance; it increases GDP without promoting inflation.
Policies to control inflation need to focus on the underlying causes of inflation in the economy. For example if the main cause is excess demand for goods and services, then government policy should look to reduce the level of aggregate demand. If cost-push inflation is the root cause, production costs need to be controlled for the problem to be reduced. Since May 1997, the Bank of England has had operational independence in the setting of official interest rates in the United Kingdom. They set interest rates with the aim of keeping inflation under control over the next two years. Monetary policy can control the growth of demand through an increase in interest rates and a contraction in the real money supply. For example, in the late 1980s, interest rates went up to 15% because of the excessive growth in the economy and contributed to the recession of the early 1990s. A rise in interest rates will lead to a fall in aggregate demand because: consumers spend less on consumer durables, often financed through loans, when interest rates rise; firms spend less on investment as fewer investment projects remain profitable at higher interest rates; the wealth of households tends to decline with higher interest rates because higher interest rates tend to have a negative impact on stocks and shares, they can also adversely affect house prices as mortgages become more expensive; the exchange rate tends to rise, making it more difficult for exporters to sell abroad and making imports more competitive against domestic producers and higher interest rates also encourage saving. Deflationary monetary policy is often not politically popular. A rise in interest rates can only curb inflation if economic growth slows or even becomes negative. A sharp deflation is likely to lead to rising unemployment as well. Keynesians and Monetarists differ in opinion regarding the presence and significance of an unemployment, inflation trade-off. Unemployment aside, there is another problem by way of using interest rates to control inflation; in the short run monetary policy can lead to a perverse increase in inflation. In the UK mortgage interest repayments are included as part of the headline inflation rate measure. A rise in interest rates leads to a rise in mortgage interest repayments. At low rates of interest, rises in mortgage interest repayments can have a significant affect on the RPI. The problem is worsened if workers are pressing for pay rises based on the RPI inflation measure. Higher interest rates could also be used to limit monetary inflation. A rise in real interest rates should reduce the demand for lending and therefore reduce the growth of broad money.
In the 1950’s and 1960’s, governments in the western world tended to use fiscal policy as their main tool to control inflation. If inflation is demand-pull in nature (too much money, chasing too few products), then reducing the level of aggregate demand in the economy will reduce inflationary pressures. Keynesians have a propensity to argue that fiscal policy can play a crucial role in cutting aggregate demand. They key variable which the government can manipulate is the PSNCR, government borrowing. If it reduces the level of borrowing it will cut aggregate demand. It can cut borrowing either by reducing the level of government spending or by increasing taxes. If it reduces government spending, there will be a multiplier effect on national income with aggregate demand falling by more than the initial cut in government spending. Governments can also influence cost-push spirals by artificially manipulating indirect tax rates. With regard to the governments own key industries, like the post office, it can reduce expected inflation by not raising prices in line with inflation, these industries may lose out on profit, but this is an attractive compromise for lower inflation. In the 1970’s the economy experienced stagflation, caused by sharp rises in world oil prices. From this time onwards Keynes’s theories with regard to inflation control have been replaced with monetarist ones.
