The Thatcher and Major Years

In 1979 Margaret Thatcher came to power in Britain - the first female Prime Minister. It was seen as a turning point for Britain, not just for this reason, but because of the effect it could have on economic policy. She was a radical woman, and her policies echoed her personality. Brutal. Defeating inflation was the key to her policies. In the run up to the election the Conservatives rethink their philosophy and come up with their "New Approach". They'd place greater emphasis on market forces, preferring small government intervention in the economy. This wouldn't be possible with the inflation problem, however. This needed to be defeated because it was distorting price signals and angering voters.

This period saw the rise of the Monetarists. They were born out of the "Chicago School" with Milton Friedman a figurehead of sorts. Their argument was fairly simple. They felt using demand management would be shooting ourselves in the foot - more demand meant more inflation and not higher output. Inflation was a monetary phenomenon, the money supply had to be cut to control it - tight financial policy was needed. In 1980, the Conservatives follow this line of thought. They raise interest rates and VAT while lowering their public borrowing. What's the result?

Well, in 1981 the economy is in recession - yet the Budget of this year sees policy tightened even further. It was a bold move, it showed that the Conservatives were really trying to tackle inflation. And it works. Inflation falls rapidly from 18% to a more acceptable 4.3% from 1980-1983. Interest rates are increased further after this and growth starts to pick up. It was a step in the right direction, but unemployment was remaining high and inflation was still higher and more volatile than other major economies.

The policy still struggled, however. They know that responding to the headline inflation rate was pointless because of the time lags in policy taking effect. They somehow needed to find an effective framework that could predict inflation in the future and respond to that level now. This indicator for when to change policy came in the form of the Medium Term Financial Strategy (1980). It was a framework that targeted the money supply - targets would be made and the broad money supply would not be allowed to rise above them. Interest rates and lower public borrowing would be used to control the money supply and keep it within the desired range. It had risks, tightening policy always carried the risk of bringing a recession.

It could have worked, but it had its problems. The targets weren't met - the money supply consistently grew faster than it was meant to and public borrowing wasn't cut enough. The policy wasn't tight enough, yet the real economy suggested the policy was too tight - domestic demand was being curbed by the interest rates and the pound soared. Britain entered a bad recession not long after. Why does this happen? A recession shouldn't really mean the money supply rises. Yet it did. This is the same period that the banks are being deregulated and firms were struggling and needing to borrow more to stay afloat. Lending controls were abolished, which means more loans were now showing on the official statistics. Overall, the money supply figures weren't an accurate guide to the economic conditions.

The Medium Term Financial Strategy is gradually abandoned because of its weaknesses - the government starts to slowly target the exchange rate by keeping the pound steady with the German mark. The pound starts at too low a level against the mark and the economy overheats in 1988. The government try and raise interest rates but it's too late as we enter recession again and end the 1980s with rising inflation. Britain needed help - and this came in the form of the European Exchange Rate Mechanism. This mechanism pinned the pound to the strong Mark allowing it to fluctuate 6% either side - Britain joined at a rate of 2.95 DM. The advantages were that it would supposedly improve fiscal discipline and therefore curb the inflation problem. It didn't. In 1992, on a day known as 'Black Wednesday' we see that it didn't. Britain finds it needing to lower its interest rates because the initial rate it joined the ERM with was over-valued. Other countries in the ERM had high interest rates which meant Britain couldn't realistically lower theirs. Speculators begin to see the pound falling and start to sell, a run on the pound starts. The aftermath of this was that the pound had to be devalued in 1992 and the credibility of the John Major government was ruined. Improvements do follow, but they can't restore the governments political position. An inflation target rate is set and interest rate decisions are given to the Bank of England who based their changes on a range of economic variables and not just the one. 

Macro-Economic Issues

The macro-economy refers to the wider economy - it's looking at an economy as a whole as opposed to individual firms or operators within an economy that micro-economics refers to. We come across macroeconomics on a daily basis: inflation and unemployment for example. The topic gets a lot of media attention and is the main cause of a lot of the criticism that politicians receive. The importance placed on macroeconomics by politicians can never be understated - they fully understand that voters want a thriving economy and therefore they strive to achieve this.

The four major economic issues are ones we will all have heard of: Economic growth, unemployment, inflation and the Balance of Payments/Exchange rate. The government aims to keep all four of these in check as part of their policy objectives. They want economic growth to be at a high, stable level. They aim to reduce unemployment because not only is it a drain on their finances in the form of unemployment benefits but it is a waste of resources. Inflation needs to be kept low and stable to make decision making easier on individuals and firms. The balance of payments wants to be in surplus, or at least balanced, so that the exchange rate isn't pushed upwards (this can fuel inflation as import prices will rise). The problem the government faces is that these policy objectives can conflict. If there's one thing you learn from this post, make it be this: The government are in a difficult position - they will struggle to achieve all four of these objectives at the same time.

At this point I am going to direct you to a previous post I've written about the circular flow of income as this will come in handy when looking at the next part. Click here to be linked to that post.

So, the macroeconomic goals of the government have a close relationship with the circular flow of income. If the withdrawals from the flow exceed the injections into the flow then we will see a case of aggregate demand falling. This subsequently will lead to a fall in economic growth, a rise in unemployment, lower inflation and a potential improvement of the balance of payments. With injections exceeding withdrawals we expect the opposite to happen. Here is a perfect example of the difficulties the government faces. A rise in aggregate demand has the potential to push the government closer to two of its goals (economic growth and a fall in unemployment) but at the same time it also pushes them further away from the other two goals (rise in inflation and a worsening balance of payments). The dilemmas of a politician. 

Exchange Rates (Macroeconomics)

Exchange rates are something that affects all of us, be it directly or indirectly. Exchange rates are basically the value of a currency compared to that of another currency. They fluctuate a lot, which leads to price changes.

I'll be using the Sterling (£) in my examples throughout. Firstly, let's look at what determines the value of a currency. The value of the £ is determined by the free market, so therefore the powers of demand and supply dictate the value of the £. The majority of the demand for the £ will come from trading partners demanding the U.K's exports and therefore needing the £ to buy them. The majority of the supply of the £ comes from us demanding foreign imports, and needing to sell the £ to get foreign currency to buy the imports.

An increase in the demand for the £ will increase the value compared to other currencies. This is often referred to as a "strengthening of the £" or an "appreciation". Obviously, a fall in demand for the £ will have the opposite effect. An increase in the supply of the £ will decrease the value compared to other currencies. This is often known as a "weakening of the £" or a "depreciation". A decrease in supply will have the opposite effect, raising the value.

Another key factor that influences the demand and supply of the £ is interest rates. If interest rates in the U.K. are high, then we will see a high demand for the £ as people will make a better return off of it in U.K. banks. This will increase the value of the currency. A decrease in interest rates will see money flow out of the U.K. in search of a better return on their investment and therefore demand and the value of the £ will fall.

There are two different exchange rate mechanisms. The first one is the floating mechanism. This is when the value of the currency is determined by the free market - the powers of demand and supply. The advantage of this mechanism is that theoretically the exchange rate should automatically adjust which will eliminate any imbalances withing the Balance of Payments. The other is the fixed mechanism. This is when the exchange rate is fixed and determined by the government or central bank of a country. The bonus to this is that it gives more stability to the value of the currency but runs the risk of goods becoming to un-competitive if it's too high or the market can be flooded if it's too low.

That's the lot for exchange rates, thanks. Also, any requests for what to come next? Post it in comments and ill see what i can do. Thanks for reading, follow the blog if you enjoy!

Monetary Policy (Macroeconomics)

Monetary policy, liked with fiscal policy is another tool the government can use to control the economy. Monetary policy involves the use of exchange rates, interest rates and the money supply to manage the economy.

Firstly, interest rates. These are set by the MPC and are mainly used in the U.K to try and achieve the inflation target of 2.0%. The theory is that a reduction in interest rates will give consumers more disposable income through lower loan repayments and this will boost the consumption factor of Aggregate Demand. Also, it should make businesses take out loans more willingly as borrowing money becomes cheaper and thus the investment factor of Aggregate Demand will rise also. Overall, a fall in in interest rates should create a rise in the real GDP of the country. It works the opposite way with a rise in interest rates, this should reduce the real GDP of the country as well as control inflation.

Interest rate changes also effect the Balance of Payments. Interest rates in the U.K. rising will cause a flow of 'hot money' into the economy as people will benefit from the higher returns of putting their money in the U.K. This flow will increase the demand for the pound, so the value will appreciate. The knock on effect of an appreciation in the value of the pound is that our exports become more expensive and it becomes cheaper for us to import goods. This will worsen the Balance of Payments. Obviously, the opposite will occur with a fall in interest rates.

Exchange rates was another tool under the title of 'Monetary Policy'. By managing the exchange rate, the Bank of England can buy and sell pounds to influence the exchange rate. This will control the competitiveness of U.K. exports and therefore help control the Balance of Payments. However, the government doesn't generally take this approach as they let the free market determine the value of the pound. One instance where this is sometimes done is in China.

The final tool under the 'Monetary Policy' heading was the money supply. This is where the government can increase or decrease the amount of money in the economy. The idea behind increasing the money supply is that it should stimulate Aggregate Demand as people have more money to spend and businesses have more money to invest. However, this method is very inflationary and is widely avoided. Decreasing the money supply will have the opposite effect to the above.

That's it, the three parts involved in the 'Monetary Policy' tool the government has at its disposal. Thanks for reading.