Tuesday, May 26, 2009

Forecast Essay, GCE Edexcel Unit 2: Assess The Effectiveness Of Monetary Policy To Combat Deflation (30m)

Monetary policy is the manipulation of interest rates to influence the movement of aggregate demand (AD) & thus overall level of economic activities. Deflation means falling price level & normally happens in period of fast contracting economy. Hence in this case, the Bank should consider cutting interest rates

With lower interest rates, more people will be induced to spend since cost of borrowing has fallen. More will take up loans to buy property, cars, LCD TV & others. With rise in demand say, for property, house prices will increase & this have positive wealth effect which will further trigger spending. Also lower interest rates discourage saving. These will lead to rightward movement of AD. Real economy will expand & price level will also increase, hopefully to the targeted level of CPI 2% +/- 1%

In period of low interest rates, firms are also encouraged to spend of capital equipments & expansion of businesses. This is because cost of financing them has fallen. It also indicates that rate of return on capital has increased. This will shift AD rightward, leading to an expansion of real GDP & rise in price level. Targeted inflation rate may be met

Lastly, lower interest rates will cause wealthy foreigners, pension funds & other wealth management companies to withdraw their money from UK. They will seek for other countries that give better yield such as European banks. In order to do so, they will need to exchange pound for other currency as in this case euro. Therefore pound will depreciate against euro. This is a good news for UK manufacturers. Demand for exports will rise & possibly resulting in increase in net exports. Again, AD shifts rightward

Having said so, consumer confidence plays a major role. In the period of pessimism, probably fall in interest rates will not be enough to prevent deflation. For instance, the Federal Reserve have reduced interest rates to between 0-0.25% & the Bank of England 0.5%, yet it fail to kickstart the economy

It is also worth to take note that monetary policy could be a blunt tool. In the period of high inflation, it can be increased indefinitely. However in period of deep recession which is often followed by deflation, interest rates cannot be cut below 0%. In the current crisis, both the monetary authority in UK & US have to abandon interest rate policy & adopt non-traditional method such as quantitative easing

Lastly, it could have severe effect lags. It is said that any interest rate cut will not produce visible results, not until at least after 18 months. This means that recent interest rate cut in UK may not produce the result until the mid of June 2010. This is likely true given that increasing number of UK people have switched to fixed rate mortgages due to fast rising interest rates prior to subprime crisis
Note: I met the Edexcel Chief Examiner for Economics, Mr. Brian Ellis last year in a conference held in Kuala Lumpur, Malaysia. According to him, although the extracts are taken from previous years article, students can apply his knowledge of current issue into the writing. Furthermore the purpose of the exam is to test students application skill

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