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Interest rates also have a direct bearing on a country’s exchange rate。 If
it is higher than that in other parable economies it will tend to support
the exchange rate at a higher rate； and if lower； the currency will tend to be
weaker （see also ‘The exchange rate’）。 There are； however； several different
interest rates and governments do not directly control them all：
。 Bank Base Rate： This is the interest set by governments； for example
by the Bank of England’s monetary mi。。ee； the US Federal Reserve
and the European Central Bank。 It is a reference point from which other
interest rates are set； but is not the actual interest rate charged by clearing
banks to their many and varied clients。
。 Libor （London Inter…bank Offered Rate）： This is the rate of interest at
which banks borrow funds from each other； an essential activity to
facilitate global trade and to se。。le contracts on futures and options
exchanges。 As such； it is the primary benchmark for short…term interest
rates globally。 The rate is set by a panel representing around 500 banks
and depends on a number of factors； including local interest rates；
expectations of future rate movements and the prevailing banking
climate。 Usually the Libor rate is lower than the rate set by central
banks to allow banks a small margin。 But if banks lose confidence in
their peers’ ability to repay then either they stop lending or they charge
a premium over the Bank Base Rate。 This was the case during the subprime
crisis in 2007/08。 Libor is both sensitive and plex。 Rates are set
in 10 currencies and for 15 different maturity dates； from an ‘overnight’
rate maturing tomorrow； a ‘spot/next’ rate that covers the period to the
day a。。er tomorrow； through weeks and months out as far as （but never
further than） one year。
。 Lending Rate： This is the rate at which banks will lend to businesses
and private individuals。 It can be anything from a fraction of a percent
above either Bank Base Rate or Libor （whichever is the higher） for blue
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； bad timing
210 The Thirty…Day MBA
or major events in a big economy with which much business is conducted。
The most important of these concerns include the following。
Employment vs unemployment
Government’s stated goal in this respect is to maintain the economy at full
employment。 That has the benefit of keeping most citizens happy； while
contributing tax to the general good。 However； if everyone is in a job the
only way a new or growing business can recruit additional staff is to poach
from other organizations； usually by offering higher wages。 That in turn
feeds into inflation； as wage prices； a major ponent of costs； are rising
without there necessarily being an increase in output。 Also； high employment
can lead to the ‘jobs for life’ a。。itude prevalent in Japan for so long
that contributed to its market inefficiencies。
In practice； governments actually set their policies to achieve an acceptable
level of unemployment。 In the UK and United States that is around 5
per cent of the labour force； while in continental Europe between 9 and 10
per cent has bee the norm。 High unemployment reduces a country’s
overall GDP through having unproductive workers。 If the unemployed
also get state welfare； as is the case particularly in continental Europe and
to a lesser extent the UK； it increases the cost for the country as a whole。
So maintaining an acceptable rather than full employment is the realistic
purpose of economic policy and governments have a number of factors and
figures to keep tabs on to achieve that goal：
。 Cyclical unemployment： This is the rate of unemployment a。。ributable
to a stage in the economic cycle。 Typically； during a downturn unemployment
will be higher than the normal target rate and lower in the
upswing。
。 Seasonal unemployment： This occurs at certain times in the year； for
example； in winter； construction and casual farm workers are more
likely to be laid off。
。 Frictional unemployment： This is the result of an economy or geographic
area within an economy moving from one type of productive
activity to another。 The shi。。 from employment in coal and steel mining
to other forms of employment； usually in the service sector； is one such
shi。。 that Western economies have experienced。
。 Structural unemployment： This is caused by workers not having the
skills and businesses not having the technology to meet new demands
being made on an economy。
。 Vacancy rate： This measures the number of unfilled jobs at any one
time。 A high level of unemployment can be partially offset against
lots of vacancies； as people take time to move from one job to another；
particularly if that requires moving home。
Economics 211
One further measure a government can take to influence unemployment
is to import labour； either through immigration or by accepting seasonal
workers from overseas。
The exchange rate
The rate at which different currencies are traded is their exchange rate； with
a high rate being viewed as a sign of economic virility。 So…called strong
rates of exchange mean that citizens and businesses find foreign goods
and services relatively cheap。 Unfortunately； it also means that foreigners
find their goods and services expensive and will buy less and seek new
suppliers in countries with more favourable exchange rates。
Most countries have their own currency； but not all governments pursue
the same exchange rate policies and each such policy involves different
costs and risks：
。 Managed and ‘not fully convertible’ is when the government exercises
political and economic control over the exchange rate and the amount of
its currency that can be moved in or out of the country。 China and India
are among many countries that fall into this category。 Such constraints
can mean that a currency drops sharply in value periodically as the
government of the day tries to hold back international pressures。
。 Pegged： For the majority of countries which have been anxiously
seeking ways to pr