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chip firms； a percent or two above for mortgages； and up to 15％ above
for credit card loans； the higher the perceived risk the higher the rate。
Economics 207
ECONOMIC POLICY AND TOOLS
Keeping the economy growing； holding inflation in check and a。。empting to
both anticipate and mitigate the worst effects of downturns in the business
cycle are the primary economic goals of government。 Dials showing the GDP
growth rate and inflation are on every government’s economy management
dashboard。 But these are not the only factors that affect an economy； nor is
se。。ing interest rates the only club in a central banker’s locker。
Policy options
The UK’s 1981 Budget； designed to remove several billion pounds from
the economy when the UK was in the depths of recession； provoked an
unprecedented le。。er from 364 economists published in The Times stating：
‘There is no basis in economic theory or supporting evidence for the
government’s present policies。’ In fact the UK economy recovered and
eventually prospered。 Even today； no politician； yet alone economist； can
agree on whether the 364 economists were right or Lady Thatcher’s then
Chancellor of the Exchequer； Sir Geoffrey； now Lord； Howe。 Although
economists disagree on almost everything； they do accept that there are
two broad categories of policy； fiscal and monetary。
Monetary policy
Monetarists； as the adherents of this school of thought are known； believe
that as the economy runs on money； controlling the supply of the amount
of money in circulation is the key to achieving growth without inflation。
If the supply of money grows faster than the economy； inflation will rise
as too much money will be chasing too few goods； too slow and growth is
stifled。 There are a number of difficulties in actually executing monetary
policies：
。 Measuring money： In the first place； agreement has to be reached on
what exactly money is。 There are at least five different and to some
extent overlapping measurements； all a。。empting to measure the liquid
assets at large in an economy。 Designated with the prefix M； these
measures range from M0； the narrowest definition which includes only
the cash held in banks and in circulation； through to M5； the broadest
measure which extends to a wide range of other short…term highly
liquid financial assets held as a substitute for deposits。 Not content
with these five measures； some now have le。。er prefixes to subdivide
further the types of liquid assets included。 If you can imagine trying
to drive a car with several speedometers you will get a feeling for the
problem。 In the world boom of 1972–73； for example； the UK’s M3 and
208 The Thirty…Day MBA
M4 grew at nearly 25％ per annum； M5 grew at over 20％； yet M1 grew
at only 10％。
。 Velocity of circulation： Money’s use is as a medium of exchange； we
swap it for goods and services； which in turn create the value in an
economy that result ultimately in GDP。 Over any interval of time； the
money one person spends can be used later by the recipients of that
money to purchase other goods and services； the suppliers of which
can then themselves spend the same cash again。 The more times cash
circulates each year the higher the velocity and hence the money supply
available to fuel GDP。 To measure money supply we need to know the
velocity of circulation but it is notoriously difficult to do； is different for
each of the Ms and can change over time。
Central bankers have three tools to help control the amount of money in
circulation：
。 Open market operations are where the central bank sells government
securities to banks； leaving them with less cash to lend。
。 Reserve requirements are the proportion of reserves a bank must keep
in relation to the amount of money it can lend。 Raising the level of
reserves reduces banks’ capacity to lend。
。 Discount rate is the interest rate the central bank charges banks。 Raising
that rate reduces the money available to lend。
Fiscal policy
A government’s approach to tax and spending is known as its fiscal policy。
Cu。。ing taxes and so giving consumers and businesses more money to
spend can stimulate an economy。 Alternatively； raising taxes can cool an
economy down if it looks like overheating。 Governments can themselves
increase spending； both by using taxes and by borrowing money raised
by issuing government securities。 The la。。er approach is termed deficit
spending and has been understood and used extensively since popularized
by Maynard Keynes in the 1920s。 He showed how governments could use
this aspect of fiscal policy either to avert a recession or to reduce its effect
on unemployment。
The spending multiplier effect
Keynesian economists deduced that government expenditure multiplies
through the economy having a far greater ripple effect than the initial sum
involved； making such activity more important than the sums themselves
may sound。 Let’s suppose the government decides to embark on a major
programme of school building； resulting in ￡100 million of salaries for
Economics 209
construction workers。 The impact of their salaries on the economy depends
on their marginal propensity to consume （MPC） – in other words； how
much of their salary they will save and how much they will spend。 If we
suppose that they will save 10 per cent of salary （the approximate 20…year
average； though at the time of writing it was less than 6 per cent）； then
they will spend 90 per cent。 That gives an MPC of 0。9； which is 90 per cent
expressed as a decimal：
The spending multiplier = 1 = 10
（1 – 0。9）
So the effect of ￡100 million of government spending on the wider economy
is 10 × ￡100 million； or ￡1；000 million； because each 90 per cent of a worker’s
ine is spent； which in turn bees someone else’s ine of which
they spend 90 per cent； and so on。
The tax multiplier
Tax reductions are another way in which governments can affect expenditure
by giving or taking money away from consumers； and that too has a
multiplier effect。 This formula is almost identical to that for the spending
multiplier。 The only difference is the inclusion of the negative marginal
propensity to consume （–MPC）。 The MPC is negative because an increase
in taxes decreases ine and hence the ability to consume。 If we again
assume that 90 per cent of ine is spent and 10 per cent saved； we have
a marginal propensity to consume of 0。9 and a marginal propensity to save
of 0。1。 This gives a tax multiplier of –9 （see below）； which means that if
taxes are raised by ￡100 million that will result in –9 × ￡100 million； in other
words； ￡900 million will be taken out of consumption。
The tax multiplier = –MPC = –0。9 = –9
MPS 0。1
The converse is of course true； were taxes reduced by ￡100 million； consumption
would rise by ￡900 million。
MORE CONCERNS
Using tools and policies to keep an economy growing and inflation low is
certainly a government’s primary goal； but they do have some other parallel
and interrelated outes in mind。 These are not so much secondary objectives；
but like inflation are more the effect of mismanagement