4.4 Flashcards
(68 cards)
1
Q
What is the money market?
A
o Market for short term loan finance for businesses and households
o Money is borrowed and lent normally for up to 12 months
o Includes inter-bank lending i.e. the commercial banks providing liquidity for each other
o Includes short term government borrowing e.g. 3-12 months Treasury Bills – to help fund the government’s budget (fiscal) deficit
2
Q
What is the capital market?
A
o Market for medium-longer term loan finance
o Capital markets are the markets where securities such as shares, and bonds are issued to raise medium to long-term financing
o Includes raising of finance by the government through the issue/sale of medium-term - long term government bonds for example 10 year and 20-year bonds (loans)
3
Q
What is the foreign exchange market?
A
o A market where currencies (foreign exchange) are traded. There is no single currency market – it is made up of the thousands of trading floors
o Gains or losses are made from exchange rates – speculative activity in the currency market is often high
o The spot exchange rate is the price of a currency to be delivered now, rather than in the future.
o The forward exchange rate is a fixed price given for buying a currency today to be delivered in the future
4
Q
What are the key ro.es of financial markets?
A
- To facilitate saving by businesses and households: Offering a secure place to store money and also earn interest
* This allows households to smooth their consumption over time, and build up deposits/ funds for large purchases - To lend to businesses and individuals: Financial markets provide an intermediary between savers and borrowers
* Banks channel funds from savers to borrowers, who would otherwise be unable to connect in an efficient way - To allocate funds to productive uses: Financial markets allocate capital to where the risk-adjusted rate of return is highest
- To facilitate the final exchange of goods and services: They provide payments mechanisms e.g. contactless payments
* Money is essential in a market economy in which division of labour is used
* Money allows a much more efficient operation of an economy, because without money, there would be a barter system - To provide forward markets in currencies and commodities: Forward markets allow agents to insure against price volatility
- To provide a market for equities: Allowing businesses to raise fresh equity to fund investment and growth
* Businesses gain finance for investment and growth from a number of sources, including retained profits, loans from banks, borrowing from money and capital markets via issuing corporate bonds (“debt financing”), or gaining funds by issuing shares (“equity financing”)
5
Q
What are the characteristics of money?
A
- Durability i.e. it needs to last
- Portable i.e. easy to carry around, convenient, easy to use
- Divisible i.e. it can be broken down into smaller denominations
- Hard to counterfeit - i.e. it can’t easily be faked or copied
- Must be generally accepted by a population
- Valuable – generally holds value over time
6
Q
What are the functions of money?
A
- Medium of exchange: money allows goods and services to be traded without the need for a barter system. Barter systems rely on there being a double coincidence of wants between two people involved in an exchange
- Store of value: this can refer to any asset whose “value” can be used now or used in the future i.e. its value can be retrieved at a later date. This means that people can save now to fund spending at a later date.
- Unit of account: this refers to anything that allows the value of something to be expressed in an understandable way that allows the value of items to be compared.
- Standard of deferred payment: this refers to the expressing of the value of a debt i.e. if people borrow today, then they can pay back their loan in the future in a way that is acceptable to the person who made the loan.
7
Q
What is narrow money?
A
o The narrow money definition of the money supply is a measure of the value coins and notes in circulation and other money equivalents that are easily convertible into cash such as short-term deposits in the banking system
8
Q
What is broad money?
A
o Broad money is a measure of the total money held by households and companies in the economy
o Broad money is made up mainly of commercial bank deposits — which are essentially IOUs from commercial banks to households and companies — and currency — mostly IOUs from the central bank.
9
Q
Give 4 key features of bank loans.
A
- Loan is provided over a fixed period (e.g. 5 years)
- Rate of interest payable is either fixed or variable
- Timing and amount of loans repayments are set by the lender e.g. a commercial bank
- Non-performing loans (“bad debts”) occur when the borrower is unable to repay some or all of the debt
10
Q
What are unsecure loans?
A
Money supported by only a borrower’s creditworthiness, rather than any type of collateral.
11
Q
What are secured loans?
A
Money you borrow that is secured against an asset you own, usually your home.
12
Q
What is equity finance?
A
- Angel Investors - Individuals who inject capital for business start-ups
- Venture Capital - Firms specializing in building high risk equity portfolios
- Stock Market Listing - Offering shares to public & institutional investors e.g. via an initial public offering (IPO)
- Crowd Funding - Raising capital from a large number of individual investors via platforms such as Crowd Cube
13
Q
What are the main functions of a commercial bank?
A
- Commercial banks provide retail banking services to household and business customers
- Banks are licensed deposit-takers providing savings accounts
- They are licensed to lend money and thereby create money e.g. via bank loans, overdrafts and mortgages
- Commercial banks are nearly all profit-seeking businesses
- A bank’s business model relies on charging a higher interest rate on loans than the rate paid on deposits
- This spread on their assets and liabilities is used to pay the operating expenses of a bank and make a profit
14
Q
How do commercial banks make profit?
A
- Interest-rate spreads – i.e. charging a higher interest rate on loans than the rate that is paid to savers
- Service fees - Includes fees charged by a bank to borrowers when arranging loans
- Brokerage percentages - many banks provide currency & share-dealing services and charge a brokerage fee for doing so.
15
Q
How do banks fail?
A
- Run on the bank
a. Depositors panic and withdraw their money fearing that the bank may collapse
b. This creates a liquidity crisis for the bank, and they may need to find emergency sources of funding - Credit crunch
a. A bank may be unable to borrow money from other banks even on an overnight basis
b. Heavy losses and collapsing capital threaten their commercial viability - High losses from bad debts / loan defaults as borrowers fail to repay
a. Credit rating of bank declines and their share price falls – this makes it harder to raise fresh finance.
16
Q
What are the limits to credit creation by banks?
A
- Market forces – i.e. the scale of profitable lending opportunities
- Regulatory policies e.g. higher capital reserve requirements imposed by a central bank
- Behaviour of consumers and businesses e.g. decisions about how much of their debt to repay
- Monetary policy – the level of policy interest rates influences the demand for loans from households and businesses, for example the demand for business loans and mortgage loans in the housing market
17
Q
What is the liquidity risk for commercial banks?
A
- Banks tend to attract short term deposits e.g. from savers
- They often lend for longer periods of time e.g. a 20-year mortgage
- As a result, a bank may not be able to repay all deposits if savers decide to withdraw their funds in one go* To reduce their risk, commercial banks will try to attract long term deposits and also hold some liquid assets e.g. cash as capital reserves
18
Q
What is the credit risk for commercial banks?
A
- This is the risk to the bank of lending to borrowers who turn out to be unable to repay some or all of their loans
- Credit risk can be controlled by research into the credit-worthiness of borrowers and also by banks having sufficient capital in reserve. Minimum capital reserves may be imposed by the financial authorities
19
Q
What are investment banks?
A
- An investment bank provides specialized services for companies and large investors:
o Underwriting and advising on securities issues and other forms of capital raising
o Advice on mergers, acquisitions & corporate restructuring
o Trading on capital markets (bonds and equities)
o Corporate research and private equity investments - An investment bank trades and invests on its own account
- Commercial banks can provide investment banking services
e.g. JP Morgan Chase
20
Q
What is market failure?
A
Market failure occurs when a market fails to deliver an economically efficiency and/or socially equitable allocation of scarce resources. Market failure is a justification for government intervention e.g. through financial regulation although this too might lead to governmental / regulatory failures as a result.
21
Q
What is asymmetric information?
A
- This type of market failure exists when one individual or party has much more information than another individual or party and then uses that advantage to exploit the other party.
- Finance is a market in information – often a potential borrower (such as a small business) has better information on the likelihood that they will be able to repay a loan than the lender.
22
Q
What are externalities?
A
- A negative externality exists when a market transaction has a negative consequence for a 3rd party.
- A positive externality exists when a market transaction has a positive consequence for a 3rd party.
23
Q
Give some examples of negative externalities that arise from financial crises.
A
- Taxpayers (taxpayers bear the cost of bank bail-out costs and the impact of fiscal austerity)
- Depositors (Risk of lost savings if a bank collapses)
- Creditors (A rise in unpaid debts can create difficulties)
- Shareholders (Lost equity from falling share prices)
- Employees (Lost jobs in finance & the wider economy especially if a financial crisis turns into a recession)
- Government (increased fiscal deficit and national debt)
- Businesses (reduced demand for goods and services and higher borrowing costs for those needing loans)
24
Q
What is moral hazard?
A
Moral hazard exists where an individual or organisation takes more risks because they know that they are covered by insurance, or they expect that the government will protect them (i.e. bail them out) from any damage incurred as a result of those risks.
25
Give examples of moral hazard.
* Individuals with large insurance policies to cover specific risks are more likely to claim against such policies.
* Government bail-outs of commercial and investment banks encourages them to engage in riskier behaviour
* Sub-prime mortgage lenders prior to 2007 were able to repackage loans into bundles bought by other institutions
26
What is a speculative bubble?
* A speculative bubble is a sharp & steep rise in asset prices such as shares, bonds, housing, commodities or crypto-currencies
* The bubble is usually fuelled by high levels of speculative demand which takes prices well above fundamental values
27
What factors can cause a speculative bubble?
* Behavioural factors e.g. the herd behaviour of investors
* Exaggerated expectations of future price rises (i.e. people expect property prices to carry on increasing)
* Irrational exuberance of investors – a term coined by Nobel-winning economist Robert Shiller
* A period of very low monetary policy interest rates – which encourages risky investment by people and by other agents in financial markets in search of higher yields
28
What is market rigging?
* This market failure is effectively collusion or abuse of the power resulting from operating in a concentrated market. Market rigging happens when some of the companies in a market act together to stop a market working as it should in order to gain an unfair advantage
* When there is a small number of firms in a market, they may choose to work together to increase their joint profits and exploit consumers.
* The Competition and Markets Authority report on UK banking in August 2016 said that “the older and larger banks, which still account for the large majority of the retail banking market, do not have to work hard enough to win and retain customers and it is difficult for new and smaller providers to attract customers.”
* Price rigging is illegal because it interferes with the natural market forces of supply and demand and harms consumers by inhibiting competition.
29
What are some barriers to entry into commercial banking?
1. Regulatory barriers – i.e. the need to be given a banking licence by the central bank
2. Natural or intrinsic barriers to entry – costs of entering the market including marketing costs, building IT and payments infrastructure
3. Strategic advantages of larger banks – including vertical integration, branch network, low rates of customer switching
4. First mover advantages including strong brand loyalty for established banks
30
What is systemic risk?
* Systemic risk is the possibility that an event at the micro level of an individual bank / insurance company could then trigger instability or collapse an industry or economy.
* The Global Financial Crisis (GFC) illustrated how deeply inter-connected the financial world has become.
* Shocks in one location (e.g. the USA) or one asset class (e.g. sub-prime mortgages) can have a sizable impact on the stability of institutions and markets around the world.
* Since the crisis, financial regulators have tried to make the banking system less vulnerable to economic shocks and create firewalls to prevent damage from systemic risk.
31
What are the main functions of a central banks?
* Monetary policy function
o Setting of the main monetary policy interest rate
o Quantitative easing (QE)
o Exchange rate intervention (managed/fixed currency systems)
* Financial stability & regulatory function
o Supervision of the wider financial system
o Prudential policies designed to maintain financial stability
* Policy operation functions
o Lender of last resort to the banking system
o Managing liquidity in the commercial banking system
o Overseeing the payments systems used by banks / retailers / credit card companies
* Debt management
o Handling the issue and redemption of issues of government debt (bonds)
32
What is monetary policy like in the UK?
* The Bank of England has been independent of the UK government since 1997
* The main aim of the Bank of England is to promote monetary and financial stability
* Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the Government's inflation target, which the Bank seeks to meet through the decisions taken by the Monetary Policy Committee (MPC)
* The policy interest rate (base rate) is set each month by the Monetary Policy Committee. The 2% inflation target is set by the UK government. Base interest rates in the UK have been below 1 percent since 2009.
33
What is the MPC?
* The Monetary Policy Committee does a thorough assessment of the UK economy 8 times a year
* They look at a range of demand/supply-side indicators
* The interest rate decision is taken after this
* Key issue is the strength of inflationary pressures and the inflation forecast for the UK over the next two years
* Inevitably there is a lot of uncertainty
* Monetary policy affects both the demand and the supply-side of the economy. It does not operate in isolation
34
What is expansionary MP?
This is a monetary stimulus and involves changes in monetary policy designed to increase aggregate demand including lower policy interest rates and measures to increase the supply of credit.
- Reducing nominal and real interest rates
- Steps to expand the supply of credit from the banking system e.g. via QE
35
What is contractionary MP?
Deflationary policies designed to lower the level / growth of aggregate demand to help control inflationary pressure. This can involve a rise in interest rates, tighter controls on bank lending and perhaps attempts to cause an exchange rate appreciation which would lower import prices
- Higher interest rates on both loans and savings
- Tightening of credit supply i.e. loans and savings
- Appreciation of the external value of the exchange rate.
36
What are the cases for maintaining a very low interest rate?
1. Inflationary pressures in many advanced countries have remained weak giving little justification for raising interest rates to control inflationary pressures
2. Some economists argue that the Phillips Curve has flattened, i.e. the trade-off between unemployment and inflation has weakened, this implies that an economy can operate at a higher level of aggregate demand and employment without risking an acceleration of inflation
3. Maintaining low interest rates help to stimulate capital investment which increases a country’s long-run productive potential
4. Low interest rates as part of an expansionary monetary policy have been helpful in supporting aggregate demand and output during an era of fiscal austerity in many developed countries.
5. Keeping interest rates low may have helped to reduce the risks of price deflation and also contributed to maintaining a competitive currency which has helped export industries
37
What are the arguments against keeping a low interest rate?
1. A rise in monetary policy interest rates would help to control demand for credit, softens the growth of the money supply and therefore helps to control demand-pull inflation especially when unemployment is very low
2. Increased mortgage rates may cause a slowdown in house price inflation and therefore help to make property more affordable over time especially for hard-pressed young families who struggle to rent as well as but
3. Higher interest rates will increase the return to saving – raising effective disposable incomes for retirees
4. Higher interest rates reduce the risk of mal-investment by business that only goes ahead because of the cheap cost of capital
5. Interest rates need to rise moderately now so that central banks can cut them in the event of a negative external shock. They need to give themselves some policy leeway when the economy next experiences a recession
38
What are the risks associated with rising interest rates?
* High levels of unsecured debt – there is a risk of a significant slowdown in consumption if retail credit becomes more expensive to service e.g. expensive credit cards
* Higher interest rates might choke off much needed business investment e.g. in new house-building and renewable energy capacity
* Rise in interest rates might cause the sterling exchange rate to appreciate thus making exports less competitive, leading to an export slowdown and a worsening external deficit
* Higher interest rates make government debt more expensive
* Higher interest rates might lead to a economic slowdown which could hit share prices, pension fund assets and dividend incomes.
39
What is QE?
* One of the main aims of quantitative easing is to increase the supply of money available for banks to lend
* It is an alternative strategy to that of cutting interest rates
* The Bank of England’s MPC’s quantitative easing (QE) programme, where the Bank creates new money to buy financial assets totalled £445 billion of assets in July 2019 - £435 billion of which are government bonds and £10 billion of commercial debt
40
How does QE work?
* QE involves the introduction of new money into the national supply by a central bank.
* In the UK the Bank of England creates new money (electronically) to buy assets (mainly bonds) from insurance companies, pension funds and commercial banks
* Increased demand for government bonds causes an increase in the market price of bonds and therefore causes their price to rise
* A higher bond price causes a fall in the yield on a bond (this is because there is an inverse relationship between bond prices and yields)
* Those who have sold their bonds may use the extra funds/cash to buy assets with higher yields such as shares of listed businesses and corporate bonds
* Commercial banks receive cash, and this increases their liquidity. This may encourage them to lend out more money
41
Summaries the main ways of which QE can work.
1. Wealth effect - lower yields (interest rates) lead to higher share and bond prices
2. Borrowing cost effect - QE lowers the interest rate on long term debt such as government bonds and mortgages
3. Lending effect - QE increases the liquidity of banks and increased lending from banks lifts incomes and spending in the economy
4. Currency effect - lower interest rates has the side effect of causing the exchange rate to weaken (a depreciation) which helps exports
42
What are the arguments in favour of QE?
* Gives a central bank an extra tool of monetary policy besides changing interest rates
* Increasing the size of the monetary base helps to lower the threat of price deflation. Without QE, the fall in real GDP would have been deeper and the rise in unemployment greater
* Lower long-term interest rates have kept business confidence higher and given the commercial banking system extra deposits to use for lending
* QE can lead to a depreciation of the exchange rate will helps to improve the price competitiveness of export industries
43
What are the criticisms of QE? (especially in the UK)
1. Ultra-low interest rates can distort the allocation of capital and also keep alive zombie companies (note: this is a key criticism of Hayekian/Austrian school)
2. QE has contributed to a surge in share prices and property values, the latter has worsened housing affordability for millions of people and also contributed to increase in rents which has worsened the geographical immobility of labour.
3. QE has done little to cause an increase in bank lending to businesses, many commercial banks have become more risk averse and charge higher interest rates to business customers.
4. QE has contributed to a decade of ultra-low interest rates which has been bad news for millions of people who rely on interest from their savings
5. Low interest rates and bond yields are a worry for pension fund investors because they worsen their deficits. If companies must pay more into their employee pension schemes, they therefore have less money to spend on investment which could harm productivity growth in the long run.
44
Who are the financial regulators in the UK financial system?
* Financial Policy Committee (FPC)
* Prudential Regulation Authority (PRA)
* Financial Conduct Authority (FCA)
* Competition and Markets Authority (CMA)
45
What are the main aims of financial market regulation?
1. Protect against the consequences of market failure
a. Protect the interest of consumers
b. Limit the monopoly power of commercial banks by encouraging increased competition
c. Protect borrowers from excessively high interest rates on loans e.g. on unsecured credit
d. Improved access to affordable finance services – this is key for growth & development and prevention of poverty in many countries
e. Balance the interests of uninformed consumers with sophisticated sellers of financial services (i.e. address problems arising from information asymmetry).
2. Encourage confidence in the economy & government
a. Promote capital investment and sustainable long run growth
b. Support trust in the banking system so that people and businesses are willing to save
3. Allow the Central Bank (e.g. the Bank of England) to perform its other roles such as lender of last resort
a. Prevent/mitigate systemic risk within financial markets that might damage the economy
46
What does the Financial Policy Committee of the BoE do?
* The FPC’s main role is to identify, monitor, and take actions to remove or reduce risks that threaten the resilience of the UK financial system as a whole
* The FPC publishes a Financial Stability Report identifying key threats to the stability of the UK financial system
* The FPC has the power to instruct commercial banks to change their capital buffers
* When the FPC decide that the risks to the financial system are growing, they may tell the commercial banks and other lenders to increase their capital buffers to help absorb unexpected losses on their assets (bad debts etc.)
* These capital buffers are part of “macro-prudential policy” - prudent means being careful at times of uncertainty.
47
What does the UK Prudential Regulation Authority do?
* The PRA is part of the Bank of England and is responsible for the prudential regulation and supervision of
around 1,700 banks, building societies, credit unions, insurers and major investment firms
* The PRA has a particular focus on the solvency of specific financial markets such as:
o Insurance providers
o Buy-to-let mortgage lenders
o Credit unions
o Other specialist lenders
48
What are liquidity ratios? How can they be used to regulate financial markets?
* A liquidity ratio is the ratio of liquid assets held by a bank on their balance sheet to their overall assets
* Commercial banks need to hold enough liquidity to cover expected demands from their depositors
* In the wake of the Global Financial Crisis the Basel Agreement require commercial banks to keep enough liquid assets, such as cash and bonds, to get through a 30-day market crisis
* A liquidity ratio may refer to a reserve assets ratio for a bank which sets the minimum liquid reserves that a bank must maintain in the event of a sudden increase in withdrawals
* Liquid Asset Ratio = Cash & balances with central banks + government bonds / divided by a bank’s total assets
49
What are capital ratios? How can they be used to regulate financial markets?
* A commercial bank's capital ratio measures the funds it has in reserve against the riskier assets it holds that could be vulnerable in the event of a crisis.
* Banks must maintain sufficient capital which includes money raised from selling new shares to investors and also their retained earnings (i.e. non-distributed profits)
50
What are Counter-cyclical capital buffers for banks?
Commercial banks are required to hold capital in the form of buffers which can be used to absorb losses during an economic downturn, enabling them to continue lending to the economy. Without these buffers, banks are more likely to cut back lending in the face of losses, making any downturn worse. The counter cyclical capital buffer rate for the UK banking system is currently set at 1%. The FPC can raise this when financial risks are rising and relax it when financial risks are easing. Counter-cyclical buffers can be summarised as following:
* Upswing in credit cycle – banks required to build up extra capital reserves
* Downswing in credit cycle – banks have more capital to help absorb losses
51
What are micro-prudential policies?
involves stronger regulation of individual financial firms such as commercial banks, payday lenders and insurance companies. It also seeks to protect individual depositors / borrowers
52
What are macro-prudential policies?
regulation seeks to safeguard the financial system as a whole i.e. protect against systemic risk. Macro-prudential seeks to make the system more resilient
53
How can you used leverage ratios to regulate the financial market?
* The leverage ratio is an indicator of the ability of a bank or building society to absorb losses
* Leverage ratio = Capital / Exposures
* The leverage ratio refers to the share of the total value of a firm’s assets and its other commitments (referred to as ‘exposures’) that is funded with capital capable of absorbing losses while a firm is a ‘going concern’.
* The lower the leverage ratio, the more that a bank or building society relies on debt to fund their activities
* In 2015, the FPC directed the Prudential Regulation Authority (PRA) to require each major UK commercial bank and building society to meet a leverage ratio requirement and hold buffers over that requirement
* The FPC have introduced a mortgage loan to income (LTI) cap which limits the number of mortgages extended at LTI ratios of 4.5 or higher to 15% of a lender’s new mortgage lending. The proportion of high loan-to-income mortgages that banks and building societies can underwrite is restricted to 15% of new mortgages.
54
How does the financial market correct externalities arising from financial instability?
Depositor protection for families with savings
Increased capital requirements for commercial banks
Stress tests for commercial banks and other financial businesses
Limits to highly-leverage mortgage lending (LTV ratios)
55
How does the financial market correct herd behaviour and speculative bubbles in financial markets?
Financial Policy Committee created to oversee financial stability
Monetary Policy Committee can raise interest rates to reduce the risk of an unsustainable housing / asset price boom
Possible regulation of use of volatile crypto-currencies
56
How can the financial market correct market rigging/ monopoly power of the banks?
Tougher competition policy for anti-competitive behaviour
Price cap on interest rates charged by pay-day lending companies
More licences to challenger banks to improve contestability
57
How can the financial market correct asymmetric information and complexity of financial products?
Penalties / compensation for miss-selling of PPI
Improved financial literacy education in schools and colleges
Auto-enrolment in workplace pensions (mandated choice
58
Give examples of capital spending.
- Construction of new motorways and bridges
- New equipment in the NHS
- Flood defence schemes
- Extra defence equipment
59
Give examples of current spending
- Salaries of NHS employees
- Drugs used in health care
- Road maintenance budget
- Army logistics supplies
60
What is the significance of government spending?
* Is a key component of aggregate demand
* Can have a regional economic impact e.g. from spending on regional infrastructure projects
* Important in providing public & merit goods
* Can help to achieve greater equity in society
61
How can government spending affect household incomes?
* Welfare state transfers
o Universal child benefits / unemployment benefit
o Public (state) pensions
o Targeted welfare payments - linked to income
* State-provided services (which offer “in-kind benefits” to people)
o Education – helps to reduce inequality of market incomes
o Health care – state provided health services
o Social housing e.g. Provided by local authorities
o Employment training
62
What are the justifications for government spending?
1. To provide a socially efficient level of public goods and merit goods and overcome market failures
a. Public goods and merit goods tend to be under-provided by the private sector
b. Improved and affordable access to education, health, housing and other public services can help to improve human capital, raise productivity and generate gains for society as a whole
2. To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society – this is also part of the process of redistributing income and wealth. Government spending has an important role to play in controlling / reducing the level of relative poverty
3. To provide necessary infrastructure via capital spending on transport, education and health facilities – an important component of a country’s long run aggregate supply
4. Government spending can be used to manage the level and growth of AD to meet macroeconomic policy objectives such as low inflation and higher levels of employment
5. Government spending can be justified as a way of promoting equity.
6. Well-targeted and high value for money public spending is also a catalyst for improving economic efficiency and competitiveness e.g. from infrastructure projects
63
What is crowding out?
The crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector where productivity might be lower. It can also lead to higher taxes and interest rates which then squeezes profits, investment and employment in the private sector.
64
Evaluate the crowding out theory.
1. The probability of 100% crowding-out is remote, especially if an economy is operating below its capacity and if there is a plentiful supply of saving available to purchase newly issued state debt
2. Keynesian economists are opposed to fiscal austerity and argue instead that fiscal deficits crowd-in private sector demand and investment.
3. Well-targeted, timely and temporary increases in government spending can absorb under-utilized capacity and provide a strong positive multiplier effect that eventually generates extra tax revenue.
4. Another criticism of the basic crowding-out theory is that the available supply of loanable funds is not limited to domestic sources, external finance is available from other countries.
65
What is crowding in?
When an increase in government spending/investment leads to an expansion of economic activity (real GDP) which in turn incentivizes private sector firms to raise their own levels of capital investment and employment. Crowding-in is a view supported by Keynesian economists.
66
What are the micro impacts of fiscal austerity?
* Output, jobs and profits in construction, transport & defence sectors
* Effects on real income and relative poverty of households
* Effective demand for goods and services e.g. welfare caps might change the pattern of demand for goods and services
* Cuts in pension spending might lead some people to delay their retirement
67
What are the macro impacts of fiscal austerity?
* Multiplier effects of cuts in public sector spending and employment
* Lower fiscal deficit might help investor confidence / attract investment
* Risks of deflationary pressures if cutting spending creates excess capacity (negative output gap)
* Bank of England more likely to keep interest rates at very low levels
68
