Understanding the EconomyIndividual Assessment

Word count: 3799Student: Jitender SinghCourse: MSc. FinanceModule Tutor: Dr. Alaa Soliman

2011

1. Apply the Keynesian Cross model to analyse how falling house prices in the

UK may cause the UK macro-economy to go again into recession. (30 marks)

According to Keynes the national expenditure determines the level of national

income and product. That means national expenditure is the cause and national

income and product is the effect. Moreover for Keynes, it is the level of spending that

determines the prosperity of a nation or group of nations.

AD = C+ I + G + (X-M)

Where AD stands for aggregate demand, ‘C’ stands for Aggregate Private

Consumption expenditure by Households, ‘I’ stands for Aggregate Private Investment

spending by Firms, ‘G’ stands for Government spending, ‘X’ stands for export and ‘M’

stands for import.

Consequently, the basic Keynesian cross model focuses on the national expenditure,

there are two main component of the national expenditure are the aggregate private

consumption expenditure by the householders and the aggregate private investment

spending by firms.

The aggregate private consumption expenditure by householders:

DIAGRAM 1Aggregate PrivateConsumption Spending (C)

0 Aggregate Disposable Income (Yd)

CF

c

a

Source: Understanding the Economy, 2010, unit 4

The CF schedule shows the volumes of Aggregate Consumption expenditure related to

a range of aggregate disposable income levels. The Consumption Function can also

be defined in terms of the following equation. Hence:

C = a + c Yd [1]

Where C is Aggregate Private Consumption expenditure, Yd is aggregate disposable

income, a is referred to as autonomous Consumption spending and c is called the

community's marginal propensity to consume.

The factors which will influence the autonomous consumption spending (a) are the

value of the total wealth, borrowing used to finance consumption, the money rate of

interest and so on. But the decrease of the house prices is a kind of the decrease in the

value of total wealth.

Whatever the distribution of wealth may be windfall changes in the valuation of assets

(e.g. houses, stocks and shares, land etc) will influence autonomous Consumption

spending. As there is windfall decline in the value of wealth; say that the ongoing

recession causes house prices to fall, then Households may fear the future thinking

their house is worth less than before, and restrain consumer spending. In general

saying the value of wealth rises, the community tends to `feel richer' and the value for

autonomous Consumption spending rises, and vice versa. By this way, it can cause the

national expenditure increased as well. The diagram below explains the relationship

between them:

DIAGRAM 2

Aggregate PrivateConsumptionExpenditure (C) (£billions)

Aggregate Disposable Income (Yd)

National Income (Y)Source: Understanding the Economy, 2010, unit 4

On the other hand, Households borrow money from the banking system to finance

large expenditures - on new houses, cars, furniture etc. The level of Household

borrowing depends on consumer expectations regarding job - hence income - security.

Greater the confidence consumers have in the future, the more likely they want to

borrow today to finance new spending. The other side of the equation is the

willingness of the banking sector to provide credit to Households. This is determined

by the financial institutions expectations that borrowers will be able to repay their debt –

what Keynes referred to as the State of Credit. But in this case, the household is not

confident for its future, moreover the banking sector is not willing to provide home loan

because of continuous decline in housing sector. The greater the use of bank

borrowing to finance present consumption, the greater the value for autonomous

Consumption spending, and vice versa.

According to Keynes, changes in the money rate of interest can influence the

propensity to consume of a community through its effect on the value of wealth.

Normally, an increase (decrease) in the rate of interest will reduce (raise) the value of

certain categories of wealth. In so far as the value of total wealth rises (falls) this will

increase (decrease) autonomous Consumption spending. But Keynes did not foresee

the huge increase in Household borrowing from the banking sector, especially after the

banking de-regulation of the 1980’s. Hence interest rates can have an effect on

Household consumption by increasing the debt repayments on money borrowed. This

is especially the case for Household mortgage debt, which makes up 80% of personal

CF0

CF1

CF2

debt in the UK (Bank of England, 1999). A rise in general interest rates will feed

through into an increase in mortgage interest rates and interest rates on other bank

loans. Inevitably if the households are not able to generate more money to repay

existing debt, they are unlikely to take out additional credit commitments; borrowing to

finance consumption may well decline and the value of autonomous Consumption

spending will fall. The reverse holds for a reduction in interest rates.

Aggregate Private Investment Spending

The business sector also sells commodities to itself; that is Firms will buy capital

equipment of various descriptions from other Firms. This Investment spending is

another important source of sales revenue for the business sector. People can spend

on transport equipments, dwellings, buildings and structures, durable goods, service

sector etc. Because of continuous decline in housing prices, the banking sector rises

and toughens its credit requirement, which becomes more difficult for potential

customers to get mortgage loan, because of which the spending capability of people

reduces, which adversely affect the other sectors, that means it causes decline in total

expenditure which ultimately affect total income and total output.

Obviously when fixed investment spending has resulted in the installation of new

machines and creation of new infrastructure it adds to the capital stock of physical

assets in an economy. The new machines/infra-structure increases the output capacity

of the business sector and increases the long-term potential growth trend of an

economy. However new machines/infra-structure can take some time to be produced,

delivered and installed - the so-called gestation period. The short run Keynesian Cross

model, therefore, puts to one side the longer term consequences of fixed investment

for productive capacity, and concentrates solely on the short term effects of Aggregate

Fixed Investment spending on National Expenditure.

Private fixed investment spending by Firms is said to depend on two main factors.

First, the expectations of Firms about the long-term future profits generated by the

utilisation of new physical equipment/infra-structure. Second, the Money rate of

interest either on finance which have been borrowed by Firms, or from other financial

assets into which Firms could have allocated their resources.(Understanding the

Economy Handbook,2010, unit 4,)

DIAGRAM 3

AggregateDemand (C+FI)(£billions)

National Income (Y)National Product (Q)

(£billions)

Source: Understanding the Economy, 2010, unit 4

When the house prices decrease, household would spend less money on additional

expenditure. The change in the diagram is AD0 curve shift to AD1. The equilibrium

point changed from F to F1. Hence, by decreasing the house prices, it can cause the

decrease and cause the decrease in national income and national product.

From all the above analysis, we can conclude that the increase in house prices can

sedate an expansion of macro-economy.

Effect of falling house prices in UK

Effect on wealth: The first effect of falling house prices is the reduction in the

wealth of the homeowners, which definitely reduce their confidence. This will

AD0

AD1

E=Y=Q

F1

F

AD0

AD1

Y0Y1

0

lead to reduce the spending; moreover people are reluctant to undertake risky

investment and borrowings.

Effect on economic growth: A fall in house prices will reduce consumer

spending and aggregate demand in the economy. Therefore, this could lead

to lower growth. It is not necessary that fall in house prices cause a recession;

there are many other factors that affect growth like investment, government

spending. However, because of the importance of housing to the UK

economy, it is quite possible falling house prices could cause a negative

multiplier effect and lead the economy into recession. (The Effect of Falling

House Prices in UK )

The Benefits of Falling House Prices: If house prices fall and causes the

fall in consumer spending, it is likely to reduce inflationary pressures in the

economy. A fall in the inflation rate will cause the MPC to consider reducing

interest rates. The MPC doesn't reduce interest rates to stop house prices

falling. - They reduce interest rates because inflation falls below their target of

inflation. The fall in interest rates reduces the cost of mortgage repayments.

This is good news for those with high mortgage interest repayments. It may

also moderate the fall in house prices because falling interest rates make

buying a house increasingly attractive. Therefore, if you have no need to

remortgage or sell your house, falling house prices can actually be beneficial

for many homeowners.

2. Apply the Keynesian cross model to analyse the impact on the UK macro

economy of the “MPC” (The Monetary Policy Committee of the Bank of

England) keeping interest rates unchanged again at 0.5%, the 18th month in a

row. Then evaluate the likelihood that such a policy can spur economic growth

in the UK economy? (40 MARKS)

Monetary policy is aimed to control the inflation pressure and is also helpful in

boosting the economy. Monetary policy affects the banking sector.

T

he change in rate of interest affects the two main components of National Expenditure

Aggregate Private Consumption expenditure by Households

Aggregate Private Investment spending by Firms

Aggregate Private Consumption expenditure by Households

Keynes accepted that changes in the money rate of interest can influence the

propensity to consume of a community through its effect on the value of wealth. As the

consumption is an important component of GDP, the influence on interest rates on

consumption is an important aspect of monetary policy. The interest rate has only an

indirect effect. As, an increase (decrease) in the rate of interest will reduce (raise) the

value of certain categories of wealth. Change in interest rate causes the value of total

wealth rises (falls) this will increase (decrease) autonomous Consumption spending. A

fall in general interest rates leads to an increase in mortgage interest rates and interest

rates on other bank loans. Borrowing to finance consumption may well rise and the

value of autonomous Consumption spending will increase.

DIAGRAM 4Aggregate PrivateConsumptionExpenditure (C) (£billions)

0 Aggregate DisposableIncome (Yd)National Income (Y)

CF0

CF1

Source: Understanding the Economy, 2010, unit 4

However taking the economy as a whole, and given the scale of Households who

borrow money to finance house purchasers and consumption spending, the overall

effect of a rise in interest rates will be to lower the value of autonomous Consumption

spending, and vice versa.

Aggregate Private Investment spending by Firms

Aggregate Private Investment spending is the second major component of national

expenditure, which can influence the economic growth. Private fixed investment

spending by Firms is said to depend on two main factors:

First, the expectations of Firms about the long-term future profits generated by

the utilisation of new physical equipment/infra-structure.

Second, the Money rate of interest either on finance which has been borrowed

by Firms, or from other financial assets into which Firms could have allocated

their resources.

The analysis is the Aggregate Private Investment spending can be illustrated in terms

of a Private Fixed Investment Function. The Function is specified in equation below.

FI = IP – i(r)

Where FI is Aggregate Private Fixed Investment spending, IP is a given level of private

fixed investment spending determined by the State of Long Term Expectations and

Animal Spirits, r is the money rate of interest and i represents the negative relationship

between fixed investment and the rate of interest.

The private fixed investment Function outlined above is illustrated in Diagram 5 below.

On the vertical axis is the money rate of interest (r) and Aggregate Private Fixed

Investment spending (FI) is on the horizontal axis. The Fixed Investment Function is

denoted by IFF.

DIAGRAM 5Money Rateof Interest (r%)

Aggregate Private Investment Spending (FI) (£billions)

Source: Understanding the Economy, 2010, unit 4

By diagram 5 we can easily interpretate with the fall in interest rate there is rise in

Aggregate private investment spending. Let suppose, the initial interest rate is r0 then

the aggregate private investment spending is FI0. When interest rate is fall from r0 to

r1, the aggregate private investment spending rises from FI0 to FI1. That means there

is inverse relation between interest rate and investment spending.

IFF

r0

FI0

r1

FI1

DIAGRAM 3

Planned Spending(£billions)

National Income (Y) National Product (Q)Source: Miles and Scoot, p.312 (£billions)

Monetary Policy, the Nominal Exchange Rate and the Housing Market

E=Y=Q

F1

F

PEr1

PEr0

Y0Y1

0

PEr0

PEr1

Official Rate

Market Rate

Asset Rate

Exchange Rate

Expectation/confidence

Net external demand

Domestic Demand

Inflation

Import prices

Domestic inflationary pressure

Total demand

Source: Monetary Policy Committee, Bank of England; Miles and Scott, p.399

Government cannot use the Interest Rate instrument without it having an effect on the

value of the Nominal Exchange Rate. Significant increases (decreases) in domestic

Interest Rates can have the effect of raising (lowering) the value of the Nominal

Exchange Rate, with the exact extent of the rise (fall) in the latter is difficult to predict.

Changes in the value of the Nominal Exchange Rate can have significant effects on

domestic inflation, competitiveness, the Net Export position, the equilibrium values for

National Income (and Product), and total employment. This means that changing

domestic Interest Rates can have a number of unintended consequences that the

monetary authorities cannot predict and do not want. Specifically this means that

changing the Money Rate of Interest can itself generate unintended macro-economic

instability.

As in UK, Monetary Policy Committee has not changed interest rate from 0.5% for 18

consecutive months.MPC has set low interest rates to increase the growth of the Total

Money Supply (an intermediate target), but the problem is the low interest rate causes

rise in inflation which is not the target of committee, as Bank of England had set 2% as

the target inflation rate, but the CPI inflation was 3.1% in July, 2010.

However, low Interest rates contributed to the significant fall of the value of Sterling

during the period. British export sectors found that the Low Exchange rate meant they

could compete in foreign markets. An inflationary Gap can create as many export

markets is coming. This Discretionary Monetary policy resulted in macro-economic

stability that can save many firms from bankrupt and large numbers of workers get their

jobs as the investment increases, which leads to increase in total expenditure.

Government cannot use the Interest Rate instrument without it having an effect on the

Housing market, hence the value of wealth. Significant decreases (increases) in

Interest Rates can have the effect of increasing (decreasing) the take up by

Households of new mortgages to buy houses, causing house price booms (slumps). As

housing wealth is an important component of the total wealth held by a community. A

rise (fall) in the value of houses then feeds through into higher (lower) autonomous

Consumption spending with implications for the equilibrium values for National Income

(and Product), and total employment. Once again this means that changing Interest

Rates can generate unintended macro-economic instability.

“An example of this was the high Interest Rate policy of the Government in the period

between 1989 and 1990 - rates of 15% for about 12 months. A high Interest rate policy

(with rates of 15% for a 12-month period) was used as an instrument to reduce

inflation. However high Interest rates increased markedly mortgage debt repayments

putting many people into arrears (and making some homeless). High interest rates

lowered the demand for houses causing large falls in house prices and the emergence

of negative housing equity ie house prices especially in the South East of England

began to fall below what Households had paid for them. The overall effect of this policy

did reduce the rate of inflation. But the price paid was that of plunging the UK economy

into the longest recession since 1932, causing many Firms to close and worker to lose

their jobs. Unintended macro-economic instability was once again the result.”

(Understanding the Economy handbook, Unit 9)

3. Apply appropriate theoretical framework to analyse how falling consumer credit

(bank credit) can slow the UK economic recovery from this biggest recession since

the great depression (30 MARKS)

Consumer Credit is very important for any financial sector of an economy. It pumps

the money supply in the market. It has been observed that the private and public

sector debt has played important role in driving the UK economy.

Let us see in 2008 the situation in UK:

• The household saving was at its lowest since 5decades and household debt

reached 100% of GDP.

• No matter the business sector was doing well but the corporate debt as share of

GDP was above 110%.

• UK banks entered recession as loans to the UK commercial property sector

accounted for almost half of all the outstanding loans to UK businesses; &

• The accumulation of debt within the financial sector was even greater. Between

2002 and 2007, there was a near tripling of UK bank balance sheets and the UK

financial system had become one of the most leveraged in the world.

The trust on public and private sector debt meant that the UK economy was

impacted badly by the financial crisis. With the tightening in credit conditions, there

was low confidence in business. UK’s export felt because the credit crunch affected

many countries who were trading partner of UK. This was the deepest and longest

recession in UK since World War II.

‘850,000 people became unemployed since the start of 2008. Business

investment fell sharply by more than 25 per cent from its peak.’ With unemployment

rising and low bank credit, people were left up to pay off debts with low disposable

income. So, no proper savings were done as the major part of income went to clear

the outstanding debts.

‘Many banks increased their debts relative to their capital during the credit

boom, leaving them with a limited buffer to cover losses. They also increased their

reliance on short-term wholesale funding, making them vulnerable to any disruption

in funding markets. This unsustainable increase in risk-taking by financial institutions,

and the consequent growth in the size, complexity, and opacity of the financial

network, increased the vulnerability of financial institutions to a change in market

sentiment and the risk of markets freezing up in times of stress.’

Unsustainable fiscal policy with low credit availability (consumer credit) would

derail the recovery by increasing uncertainty and raising the overall cost of

investment. It was seen in euro that that with lack of confidence in country’s skill to

meet debt duty have caused destabilise in financial market. (Financing private sector

recovery, 2010)

Now with bank being not able to manage the losses during credit crunch, the

consumers got affected as there was low lending option available. Falling consumer

credit was due to:-

As interest rates were too low, it affected the savings habit of consumer. Consumer

didn’t want to save at lower interest rates. Along with that, the fall in housing prices

and housing sector raised the unemployment level in the country. People were left

with the option of ultimately spending as low as possible and this resulted in low

supply of money in the market. With supply of money in market, there is only one

way for economy like UK, i.e.is to slow recovery from recession.

Business firms were not able to expand further or move upward as the loans were

not available to them as feasible rates. Many bank collapsed, resulting in low

availability of funds. Since, funds were not available there was low expansionary

policy adopted by the firms. Many sectors like manufacturing and financial declined.

So the output also got decreased, this again affected the people as unemployment

level rose. The more the unemployment level, the more the economy gets affected.

Housing market i.e. the real estate sectors saw a significant fall. As there was fall in

demand of house due to low prices. People thought that the houses available at low

prices would fall further, so they didn’t opt for it and bank credit felled in parallel to it.

So, there was increase in unemployment in this sector and with no job people had

low income. The option to go for credit was not preferred by people since they knew

that they couldn’t pay off the debts. Also, the previous taken debts were still unclear;

this gave no space for people to go for monetary loan.

Now let us have a glance of how much fall in figures of credit took place in UK:-

“Outstanding credit card, loan and overdraft debts were reduced by £579m during

the month, the biggest contraction in unsecured lending since Bank of England

records began in their current format in 1993. It is only the sixth time on record that

repayments for consumer credit have outstripped new borrowing. The contraction in

unsecured credit was driven by strong repayments on loans and overdrafts, with

outstanding borrowing falling by £713m during October. But credit card lending rose

by £134m, nearly double the £78m increase seen during the previous month.

Howard Archer, chief UK and European economist at IHS Global Insight, said that

the record net repayment in consumer credit in October is clearly the consequence

of many consumers' desire to reduce their debt, low demand for credit, and a lack of

availability of unsecured credit from banks."

“Net mortgage lending, which strips out redemptions and repayments, totalled

£922m in October, up slightly on both the previous month and the six-month

average. But it remained well down on levels of more than £9bn seen regularly

during 2006 and 2007. The number of people remortgaging remained subdued, with

just 24,596 loans approved, down on both the previous month's figure and the recent

average. Archer said that the Bank of England data indicate that mortgage activity

continues to firm gradually from the record low seen in November 2008, supported

by low mortgage interest rates and the significant fall in house prices from their 2007

peak to their March/April 2009 trough. But he added that with housing market activity

still at a relatively low level compared to long-term norms, unemployment high and

still rising, earnings growth low and still was falling, and house price/earnings ratios

currently moving back up, we suspect that the recent firming in house prices will

fizzle out before long."

Building society mortgage customers repaid £521m more than was advanced during

October, the tenth consecutive month during which mortgage lending has

contracted. Consumers also withdrew £1.24bn more than they paid into building

society accounts, the eighth month in a row that withdrawals outstripped deposits.

(Consumer borrowing falls record levels, 2010)

References:

Leeds Metropolitan University (2010), Understanding the Economy Handbook

Miles, D and Scott, A. (2005) Macroeconomics- Understanding the Wealth of

Nations, 2nd ed., Singapore: John Wiley and Sons

HM Treasury,(2010) Financing a private sector recovery [internet], July 2010,

Assessed From: http://www.bis.gov.uk/assets/biscore/corporate/docs/f/10-1081-

financing-private-sector-recovery.pdf [ Assessed on 5 January,2011]

Guardian, (2010) Consumer borrowing falls record levels [Internet] Assessed

from: Guardian <http://www.guardian.co.uk/money/2009/nov/30/consumer-

borrowing-falls-record-levels> [Assessed on 06 January, 2011]