economics

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Merit goods Merit goods are goods that would be under-provided in a pure free-market economy. This is because they have external benefits that people would not take into account when they made their decisions about how much to consume. An example is vaccinations. As a result of people being vaccinated we keep disease out of the country, but if it was left just to the market many people might choose to take the risk and not pay for vaccinations. This could have negative effects for society.

Monetary Policy Committee The Monetary Policy Committee is a committee of the Bank of England chaired by the Governor that meets monthly to set the level of interest rates in the economy. They set interest rates according to the targets they have been set for inflation. If they feel inflation is set to rise they may increase interest rates and vice-versa.

Fiscal policy Fiscal policy is the use of government expenditure and taxation to try to influence the level of economic activity. An expansionary (or reflationary) fiscal policy could mean

ɨ cutting levels of direct or indirect tax




ɨ increasing government expenditure

The effect of these policies would be to encourage more spending and boost the economy. A contractionary (or deflationary) fiscal policy could be

ɨ increasing taxation - either direct or indirect

ɨ cutting government expenditure

These policies would reduce the level of demand in the economy and help to reduce inflation.

Inflation Inflation is a sustained increase in the general price level. In other words it is the rate at which prices are increasing. It can be measured either monthly, quarterly or annually. It is usually measured by the Retail Price index.

Cost-push inflation Cost-push inflation occurs when a companys costs rise and to compensate they have to put their prices up. Cost increases may happen because wages have gone up or because raw material prices have increased.

INFLATION - INTRODUCTION

Monetary policy is about setting interest rates to control inflation. It sounds straightforward enough. But to undertake the Interest Rate Challenge, participants will need to have some understanding of what inflation is and how it occurs. And they will need to know how interest rates are used to control inflation - how monetary policy works. This section provides some background to set teams on their way. There is no need to know all the material back to front. The aim is to give teams a flavour of what matters when interest rates are set.

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In very broad terms, each household that owns or is buying its own property has on average positive equity worth about £45,000. This is the difference between the average house price and the average outstanding mortgage and this represents a figure of more than twice the national average wage. Although it is hard to convert this wealth into cash, there are two macro economic effects that cause concern to policymakers.

ɨ The first and most obvious is that as households feel their wealth growing, they feel less inclined to save. As Chart 1. shows, over the long-term, UK consumers have on average saved, or not spent, a sum equivalent to %-10% of income. That ratio currently is lower (.8%) than it has been at any time since the series began in 164. What is also very clear is that the propensity to save in the last 0 years has fallen fastest at times when house prices have been rising fastest. (Comparisons with earlier periods are less relevant because of lower levels of home ownership and lower real incomes which made saving less likely.)

ɨ There are other factors contributing to a falling saving ratio (such as increasing confidence about job prospects, fewer fears of redundancy and lower interest rates which offer poorer nominal returns on savings) but housing is central to the argument. A rise in consumer confidence, the so-called feel good factor will encourage consumers to spend and borrow.

ɨ The resulting threat of inflation has in the past led the authorities to raise interest rates to slow spending. By raising the cost of mortgages, this policy reduces disposable incomes and cuts spending. The cost of borrowing will also be raised, which will be another downward pressure on spending as will the fact that the rise in house prices is likely to slow, or be choked off altogether if rates go high enough. (The doubling of base rates in a 15 month period in 188-8 led to house prices falling.)

Chart1_ Savings rates.xlsChart1_ Savings rates.xls

Source ONS

ɨ A second way house prices can underpin the rapid growth of consumer spending is by the mechanism of equity release. Often of a longer-term nature than credit card borrowing or overdrafts, homeowners unlock some of the equity they have built up in their property to support consumption. Repayments are frequently linked to the existing mortgage and the value to the homeowner of pursuing this course depends on the future trend of house prices and interest rates.

ɨ Many financial institutions make this type of facility readily available and in the late 180s, as Chart 1.4 shows, it added another 8% of potential spending to an already overheated consumer sector. With house prices once again rising, equity release is starting to pick up. It is not yet at a level which would worry the Monetary Policy Committee but, given how unbalanced the UK economy has become in 000 and 001, the fact that equity release is starting again to edge up, will not have escaped their attention.

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