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Let's get technical: managing the economy

Gareth John explains the devices governments can use to help manage the economy

July 2016

Are you sitting comfortably? Then I’ll begin. Once upon a time there were two pretty princesses…
I was reading my daughters their bedtime story one night when they asked me about the different ways that the government can manage the performance of the economy. Given the relevance of our discussion to some AAT papers (not to mention a typical career in finance!) I thought I would share my thoughts with you.
The performance of the economy of a country is extremely important to everyone who lives there as it affects the availability of jobs, the wealth of the population, the prices of goods for sale, interest rates on loans and exchange rates, among many others aspects of day-to-day business – and life.
If an economy is not growing this is known as a recession and can lead to unemployment and a reduced level of wealth in the economy. If an economy is growing very quickly this can seem good in the short term, but often leads to a recession when the ‘bubble bursts’ (in the same way that a big night out can leave you feeling rather poorly the next day).
In essence, the government doesn’t want the growth of the economy to be too slow or too fast; just a sustainable level of modest growth. This is sometimes referred to as the ‘Goldilocks economy’ as it is ‘not too hot, and not too cold’.
The government takes an active role in trying to manage the performance of the economy and this can have an impact on the businesses that operate there. There are two principal forms of government economic policy; monetary policy and fiscal policy.

Monetary policy
Monetary policy is the way that the government manages the economy by influencing the supply of money (hence ‘monetary’ policy). In general terms:
• If the economy is not growing fast enough the government will want to increase the supply of money to improve levels of demand and speed the economy up.
• If the economy is growing too fast the government will want to reduce the supply of money to slow the economy down in order to prevent it becoming a ‘bubble’.
There are different ways that the government can manage the supply of money in the economy:
• Changing interest rates (the most common approach): in a recession, the Bank of England may reduce interest rates. This will reduce the cost to businesses and individuals of borrowing money and also makes it less attractive to save the money that they do have. Both of these things will increase spending and result in greater levels of demand for goods that will help to get the country out of the recession.
• Influencing bank lending: in a boom the government can sell gilts (forms of low-risk investment) to banks. This will reduce the amount of money that the banks have to lend, therefore reducing the money supply. In a recession they can buy back these gilts to give money back to the banks to allow them to lend more which will increase the money supply.
• Altering the availability of consumer credit: if the government encourages extension of additional credit to the public they are likely to spend more as a result which will help to improve demand levels in the economy.
• Creating more money: the government can create extra money (possibly by literally printing more banknotes) and pump this into the economy. The government does this by buying assets from commercial banks in exchange for the newly created money. This will give the banks more money in their accounts to lend out to businesses and individuals.

Quantitative easing
In recent years many governments throughout the world have engaged in quantitative easing (QE) as a way of improving economic performance during the worldwide financial crash. QE is an unconventional form of monetary policy where the Bank of England creates new money electronically in order to buy investments like government debt back from investors such as banks.
With the extra money they now have the banks can lend the money to people in the economy. This should lead to an increase in the amount the people have to spend which will help to fuel growth of the economy during a recession.
One of the reasons that QE has been used in the past few years is that interest rates are already very low (virtually 0% in a lot of countries) which makes the normal monetary policy approach of reducing interest rates to speed up the economy a bit useless. As a result, governments have felt the need to pump money into their economy directly. As the level of economic activity increases this should lead to reduced levels of unemployment in the economy but can lead to higher levels of inflation.

Fiscal policy
Fiscal policy is how the government manages the economy by changing taxes and government spending.
• By increasing taxes (income tax, corporation tax, national insurance, stamp duty, etc) the government can take money out of the economy and therefore slow down the rate of growth. Conversely, reducing taxes can help to speed up an economy during a recession as businesses and individuals have more money to spend on buying products.
• By increasing government spending on things like building new hospitals or roads the government can pump money into the economy to help promote faster economic growth.
You can probably imagine that the overall impact of fiscal policy depends on whether the amount of money taken out of the economy is greater than, or smaller than, the amount put into the economy by government spending.
• If the amount of government spending is greater than tax revenue then the net effect should be an increase in the amount of money in the economy, which should lead to growth in economic activity. This is sometimes called an ‘expansionary’ fiscal policy and would be used in a recession.
• If the amount of government spending is lower than tax revenue then the net effect should be a decrease in the amount of money in the economy and a reduction in economic activity. This is called a ‘contractionary’ fiscal policy.
It will be interesting to see over the next few years how the government chooses to manage the economy in light of the recent referendum to leave the EU. Hopefully, we will all live happily ever after

• Gareth John is a tutor/director with First Intuition and helps to manage their AAT distance learning programme

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