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Articles for the ‘Essentials of Economics: Ch 12’ Category

Accelerating interest in the interesting case of UK interest rates

As John reminds us in his blog A seven year emergency we have now seen the official Bank Rate at 0.5 per cent for the past seven years. Understandably many attribute the financial crisis that led to the easing of monetary policy to the lending practices of commercial banks. Consequently, it is important that we better understand (and monitor) banks’ behaviour. Some argue that these practices are affected by the macroeconomic environment, with credit conditions varying across the business cycle. We consider here what recent patterns in interest rates might tell us about credit conditions.

One way in the macroeconomic environment might affect commercial banks’ lending practices is through the difference between banks’ lending rates and the official Bank Rate. We can think of such interest rate differentials – or spreads – as a credit premium. In other words, the greater are commercial borrowing rates relative to the Bank Rate, the greater the credit premium being demanded by banks. On the other hand, the lower the interest rate on borrowing relative to the Bank Rate, the smaller the credit premium.

Some economists argue that interest-rate differentials will fall when the economy is doing well and increase when the economy is doing less well. This is because the probability of default by borrowers is seen as smaller when the macroeconomic environment improves. If this is the case, it will tend to amplify the business cycle, since economic shocks will have larger affects on economic activity.

Consider a positive demand-side shock, such as a rise in consumer confidence, which lowers the propensity of households to save. As the positive shock causes the economy’s aggregate demand to rise, the economy grows. This growth in economic activity might result in lower borrowing rates offered by commercial banks relative to the official Bank Rate. Since savings rates tend to be close to the official Bank Rate, this also means that the cost of borrowing falls relative to the interest rates on savings. This financial effect further stimulates the demand for credit and, as a consequence, aggregate demand and economic activity. It is an example of what economists called the financial accelerator.

Similarly, the financial accelerator means that negative shocks depress economic activity by more than would otherwise be the case. A fall in consumer confidence, for example, would cause economic activity to fall as aggregate demand weakens. This, in turn, causes banks to raise borrowing rates relative to the Bank Rate and savings rates. This further dampens economic activity.

The chart shows the Bank Rate along with the average unsecured borrowing rate on loans by Monetary Financial Institutions (MFIs) of £10 000. (Secured borrowing is that which is secured against property.) We use this borrowing rate to capture general trends in commercial borrowing rates.

As expected, we can see that the borrowing rate is greater than the Bank Rate. In other words, there is a positive interest-rate differential. However, this differential is seen to vary. It falls sharply in the period up to the financial crisis. In early 2002 it was running at 8 percentage points. By summer 2007 the differential had fallen to only 1.7 percentage points. (Click here to download a PowerPoint of the chart.)

The period from 2002 to 2007 was characterised by consistently robust growth. The UK economy grew over this period by about 2.7 per cent per annum. This would certainly fit with the story that economic growth may have contributed to an easing of credit conditions which, in turn, helped to induce growth. Regardless, the falling interest-rate differential points to credit conditions easing.

The story from 2008 changes very quickly as the interest-rate differential increases very sharply. In 2009, as the official Bank Rate was cut to 0.5 per cent, the unsecured borrowing rate climbed to close to 10.5 per cent. Consequently, the interest-rate differential rose to 10 percentage points. Inter-bank lending had dried up with banks concerned that banks would default on loans. The increase in interest rates on lending to the non-bank private sector was stark and evidence of a credit market disruption.

The interest-rate differential has steadily declined since its peak at the end of 2009 as the unsecured borrowing rate has fallen. Hence credit conditions have eased. In fact, in February 2016 our indicative interest rate differential stood at 3.8 percentage points, unchanged from its level in January. This is its lowest level since July 2008. Furthermore, today’s differential is lower than the 6.5 percentage point average over the period from 1997 to 2003, before the differential then went on its pre-crisis fall.

Given concerns about the impact of credit cycles on the macroeconomy we can expect the authorities to keep a very keen eye on credit conditions in the months ahead.

Bank holds UK interest rates at 0.5% BBC News (17/3/16)
UK’s record low interest rates to continue in 2016 The Guardian, Katie Allen (3/3/16)
Big rise in consumer credit in January BBC News, Brian Milligan (29/2/16)
Household debt binge has no end in sight, says OBR The Telegraph, Szu Ping Chan (17/3/16)

Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database – interest and exchange rates data Bank of England


  1. Why would we expect banks’ borrowing rates to be higher than the official Bank Rate?
  2. What factors might lead to a change in the interest-rate differential between banks’ borrowing rates and the official Bank Rate?
  3. How would we expect a credit market disruption to affect the interest-rate differential?
  4. Explain how the financial accelerator affects the change in the size of the economy following a positive demand shock.
  5. Explain how the financial accelerator affects the change in the size of the economy following a negative demand shock.
  6. What is the impact of the financial accelerator of the amplitude of the business cycle?
  7. How might banks’ credit criteria change as the macroeconomic environment changes?
  8. How might regulators intervene to minimise the effect of the financial accelerator?
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The political business cycle – mark II

During the 1970s, commentators often referred to the ‘political business cycle’. As William Nordhaus stated in a 1989 paper. “The theory of the political business cycle, which analyzes the interaction of political and economic systems, arose from the obvious facts of life that voters care about the economy while politicians care about power.”

In the past, politicians would use fiscal, and sometimes monetary, policies to manipulate aggregate demand so that the economy was growing strongly at the time of the next election. This often meant doing unpopular things in the first couple of years of office to allow for popular things, such as tax cuts and increased government transfers, as the next election approached. This tended to align the business cycle with the election cycle. The economy would slow in the early years of a parliament and expand rapidly towards the end.

To some extent, this has been the approach since 2010 of first the Coalition and now the Conservative governments. Cuts to government expenditure were made ‘in order to clear up the mess left by the previous government’. At the time it was hoped that, by the next election, the economy would be growing strongly again.

But in adopting a fiscal mandate, the current government could be doing the reverse of previous governments. George Osborne has set the target of a budget surplus by the final year of this parliament (2019–20) and has staked his reputation on achieving it.

The problem, as we saw in the blog, Hitting – or missing – the government’s self-imposed fiscal targets is that growth in the economy has slowed and this makes it more difficult to achieve the target of a budget surplus by 2019–20. Given that achieving this target is seen to be more important for his reputation for ‘sound management’ of the public finances than that the economy should be rapidly growing, it is likely that the Chancellor will be dampening aggregate demand in the run-up to the next election. Indeed, in the latest Budget, he announced that specific measures would be taken in 2019–20 to meet the target, including a further £3.5 billion of savings from departmental spending in 2019–20. In the meantime, however, taxes would be cut (such as increasing personal allowances and cutting business rates) and government spending in certain areas would be increased. As the OBR states:

Despite a weaker outlook for the economy and tax revenues, the Chancellor has announced a net tax cut and new spending commitments. But he remains on course for a £10 billion surplus in 2019–20, by rescheduling capital investment, promising other cuts in public services spending and shifting a one-off boost to corporation tax receipts into that year.

But many commentators have doubted that this will be enough to bring a surplus. Indeed Paul Johnson, Director of the Institute for Fiscal Studies, stated on BBC Radio 4′s Today Programme said that “there’s only about a 50:50 shot that he’s going to get there. If things change again, if the OBR downgrades its forecasts again, I don’t think he will be able to get away with anything like this. I think he will be forced to put some proper tax increases in or possibly find yet further proper spending cuts”.

If that is the case, he will be further dampening the economy as the next election approaches. In other words, the government may be doing the reverse of what governments did in the past. Instead of boosting the economy to increase growth at election time, the government may feel forced to make further cuts in government expenditure and/or to raise taxes to meet the fiscal target of a budget surplus.

Budget 2016: George Osborne hits back at deficit critics BBC News (17/3/16)
George Osborne will have to break his own rules to win the next election Business Insider, Ben Moshinsky (17/3/16)
Osborne Accused of Accounting Tricks to Meet Budget Surplus Goal Bloomberg, Svenja O’Donnell and Robert Hutton (16/3/16)
George Osborne warns more cuts may be needed to hit surplus target Financial Times, Jim Pickard (17/3/16)
6 charts that explain why George Osborne is about to make austerity even worse Independent, Hazel Sheffield (16/3/16)
Budget 2016: Osborne ‘has only 50-50 chance’ of hitting surplus target The Guardian, Heather Stewart and Larry Elliott (17/3/16)
How will Chancellor George Osborne reach his surplus? BBC News, Howard Mustoe (16/3/16)
Osborne’s fiscal illusion exposed as a house of credit cards The Guardian, Larry Elliott (17/3/16)
The Budget’s bottom line: taxes will rise and rise again The Telegraph, Allister Heath (17/3/16)

Reports, analysis and documents
Economic and fiscal outlook – March 2016 Office for Budget Responsibility (16/3/16)
Budget 2016: documents HM Treasury (16/3/16)
Budget 2016 Institute for Fiscal Studies (17/3/16)


  1. Explain the fiscal mandate of the Conservative government.
  2. Does sticking to targets for public-sector deficits and debt necessarily involve dampening aggregate demand as an election approaches? Explain.
  3. For what reasons may the Chancellor not hit his target of a public-sector surplus by 2019–20?
  4. Compare the advantages and disadvantages of a rules-based fiscal policy and one based on discretion.
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A Brazilian legacy?

It doesn’t seem long ago that we were looking at the prospects of Brazil for hosting the Football World Cup. Now, we turn to the same economy, but this time for the Olympics. It is often the case that hosting big global sporting events can give a boost to the host nation, but is Brazil prepared for it? Did the World Cup bring the expected economic boosts? Some argue that the Olympics is just what Brazil needs, but others suggest it will only worsen the economic situation in the world’s seventh largest economy.

Brazil’s economic performance in the past year was not good. In fact, it was one of the worst performing nations of any major economy, with GDP falling by 3%. This is a very different country from the one that was awarded this biggest of sporting events. Despite these difficult times, Brazil’s government maintains that the country is ready and that the games will be ‘spectacular’.

Key to hosting a sporting event such as the Olympics is the infrastructure investment and as a key component of aggregate demand, this should be a stimulant for growth and job creation. However, with the economy still struggling, many are concerned that the infrastructure won’t be in place in time.

Other benefits from this should be the boost to growth driven by athletes and spectators coming from around the globe, buying tickets, memorabilia, accommodation, food and other items that tourists tend to buy. A multiplier effect should be seen and according to research has the potential to create significant benefits for the whole economy and not just the local regions where events take place. You can look at similar analysis in blogs written about Tokyo: 2020 Tokyo Olympics and London: The London Olympics legacy: a cost–benefit analysis and Does hosting the Olympics Games increase economic growth?

But, is this really likely to happen, especially given the somewhat lacklustre boost that the Brazil World Cup gave to the economy? The following articles consider this.

Rio 2016: Can Games bounce back from Brazil economic woes? BBC News, Bill Wilson (11/03/16)
Does hosting the Olympics actually pay off? It’s the economy, Binyamin Applebaum (5/08/14)
Rio Olympics no help to Brazil economy based on World Cup Bloomberg, Raymond Colitt (16/01/15)
The economic impact of Brazil’s 2014 World Cup and 2016 Olympics Saxo Group, Trading Floor, Sverrir Sverrisson (27/08/12)
Special Interview: Cost–benefit analysis of hosting the World Cup, Olympics Al Arabiya, Ricardo Guerra (3/7/14)


  1. How might you carry out a cost–benefit analysis to decide whether to host a big sporting event?
  2. Are there any externalities that might result from hosting the Olympics? How easy is it to estimate their monetary value? Should this be taken into account by a country when making a decision?
  3. Why might there be a boost to aggregate demand prior to the Olympics?
  4. Why might there be a multiplier effect when a nation hosts the Olympics or another sporting event?
  5. Might there be benefits to Brazil’s neighbours from its hosting the Olympics?
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Hitting – or missing – the government’s self-imposed fiscal targets

On election to office in May 2015, the UK’s Conservative government set new fiscal targets. These were set out in an updated Charter for Budget Responsibility. As Box 12.3 in Essentials of Economics (7th edition) states:

The new fiscal mandate set a target for achieving a surplus on public-sector net borrowing by the end of 2019/20. More controversially, government should then target a surplus in each subsequent year unless real GDP growth falls below 1 per cent … Meanwhile, the revised supplementary target for public-sector debt was for the net debt-to-GDP ratio to fall each year from 2015/16 to 2019/20.

What is more, the Charter requires the government to set a cap on welfare spending over a five-year period. Such spending includes spending on pensions, tax credits, child benefit and unemployment benefit. In July 2015 the Chancellor set this cap at £115bn for 2016/17, a reduction of £12bn.

Whether or not such a tight fiscal target is desirable, the government has been missing the target. In November last year, the Chancellor had to backtrack on his plans to make substantial reductions in tax credits and as a result the welfare cap has been breached, as the following table from page 5 of the December 2015 House of Commons briefing paper shows.

Also, with the slowing of economic growth, the Chancellor has stated that he will miss the requirement for a fall in the net debt-to-GDP ratio unless further cuts in government spending are made, equivalent to 50p in every £100.

But, if the economy is slowing, is it right to cut government expenditure? In other words, should there be some discretion in fiscal policy to respond to economic circumstances? There are two issues here. The first is whether the resulting cut in aggregate demand will be detrimental to growth. The second is who will bear the cost of such cuts. Critics of the government claim that it will largely the poor who will lose if the cuts are made mainly from benefits.

The articles below examine the public finances, the difficulties George Osborne has been facing in sticking to his fiscal mandate and the options open to him.

Budget 2016: Osborne’s economic fitness regime BBC News, Andy Verity (14/3/16)
Budget 2016: George Osborne fuels speculation of nasty shocks The Guardian, Larry Elliott and Anushka Asthana (14/3/16)

Official publications
Charter for Budget Responsibility: Summer Budget 2015 update HM Treasury (July 2015)
OBR publications, including ‘Economic and fiscal outlook’ and ‘Fiscal sustainability report’ Office for Budget Responsibility


  1. Outline the main points of the Charter for Budget Responsibility (CBR).
  2. What are the arguments for sticking to fiscal rules, such as those in the CBR?
  3. What are the arguments for using discretion to adjust fiscal policy as economic circumstances change?
  4. Compare the Conservative government’s fiscal mandate with the newly announced approach to fiscal policy of the Labour opposition?
  5. How does the Labour Party’s new approach differ from the Golden Rule followed by Gordon Brown as Chancellor in the Labour government from 1997 to 2007?
  6. What factors will determine whether or not the government will return to meeting the rules set out in the Charter for Budget Responsibility?
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A seven-year emergency

Seven years ago (on 5 March 2009), the Bank of England reduced interest rates to a record low of 0.5%. This was in response to a deepening recession. It mirrored action taken by other central banks across the world as they all sought to stimulate their economies, which were reeling from the financial crisis.

Record low interest rates, combined with expansionary fiscal policy, were hoped to be enough to restore rates of growth to levels experienced before the crisis. But they weren’t. One by one countries increased narrow money through bouts of quantitative easing.

But as worries grew about higher government deficits, brought about by the expansionary fiscal policies and by falling tax receipts as incomes and spending fell, so fiscal policy became progressively tighter. Thus more and more emphasis was put on monetary policy as the means of stimulating aggregate demand and boosting economic growth.

Ultra low interest rates and QE were no longer a short-term measure. They persisted as growth rates remained sluggish. The problem was that the higher narrow money supply was not leading to the hoped-for credit creation and growth in consumption and investment. The extra money was being used for buying assets, such as shares and houses, not being spent on goods, services, plant and equipment. The money multiplier fell dramatically in many countries (see chart 1 for the case of the UK: click here for a PowerPoint) and there was virtually no growth in credit creation. Broad money in the UK (M4) has actually fallen since 2008 (see chart 2: click here for a PowerPoint), as it has in various other countries.

Additional monetary measures were put in place, including various schemes to provide money to banks for direct lending to companies or individuals. Central banks increasingly resorted to zero or negative interest rates paid to banks for deposits: see the blog posts Down down deeper and down, or a new Status Quo? and When a piggy bank pays a better rate. But still bank lending has stubbornly failed to take off.

Some indication that the ‘emergency’ was coming to an end occurred in December 2015 when the US Federal Reserve raised interest rates by 0.25 percentage points. However, many commentators felt that that was too soon, especially in the light of slowing Chinese economic growth. Indeed, the Chinese authorities themselves have been engaging in a large scale QE programme and other measures to arrest this fall in growth.

Although it cut interest rates in 2009 (to 1% by May 2009), the ECB was more cautious than other central banks in the first few years after 2008 and even raised interest rates in 2011 (to 1.5% by July of that year). However, more recently it has been more aggressive in its monetary policy. It has progressively cut interest rates (see chart 3: click here for a PowerPoint) and announced in January 2015 that it was introducing a programme of QE, involving €60 billion of asset purchases for at least 18 months from March 2015. In December 2015, it announced that it would extend this programme for another six months.

The latest move by the ECB was on March 10, when it took three further sets of measures to boost the flagging eurozone economy. It cut interest rates, including cutting the deposit rate paid to banks from –0.3% to –0.4% and the main refinancing rate from –0.05% to –0%; it increased its monthly quantitative easing from €60 billion to €80 billion; and it announced unlimited four-year loans to banks at near-zero interest rates.

It would seem that the emergency continues!

QE, inflation and the BoE’s unreliable boyfriend: seven years of record low rates The Guardian, Katie Allen (5/3/16)
The End of Alchemy: Money, Banking and the Future of the Global Economy by Mervyn King – review The Observer, John Kampfner (14/3/16)
How ‘negative interest rates’ marked the end of central bank dominance The Telegraph, Peter Spence (21/2/16)
ECB stimulus surprise sends stock markets sliding BBC News (10/3/16)
5 Takeaways From the ECB Meeting The Wall Street Journal, Paul Hannon (10/3/16)
ECB cuts interest rates to zero amid fears of fresh economic crash The Guardian, Katie Allen and Jill Treanor (10/3/16)
Economists mixed on ECB stimulus CNBC, Elizabeth Schulze (10/3/16)
ECB’s Draghi plays his last card to stave off deflation The Telegraph, Ambrose Evans-Pritchard (10/3/16)
ECB cuts rates to new low and expands QE Financial Times, Claire Jones (10/3/16)
Is QE a saviour, necessary evil or the road to perdition? The Telegraph, Roger Bootle (20/3/16)

ECB materials
Monetary policy decisions ECB Press Release (10/3/16)
Introductory statement to the press conference (with Q&A) ECB Press Conference, Mario Draghi and Vítor Constâncio (10/3/16)
ECB Press Conference webcast ECB, Mario Draghi


  1. What are meant by narrow and broad money?
  2. What is the relationship between narrow and broad money? What determines the amount that broad money will increase when narrow money increases?
  3. Explain what is meant by (a) the credit multiplier and (b) the money multiplier.
  4. Explain how the process of quantitative easing is supposed to result in an increase in aggregate demand. How reliable is this mechanism?
  5. Find out and explain what happened to the euro/dollar exchange rate when Mario Draghi made the announcement of the ECB’s monetary measures on 10 March.
  6. Is there a conflict for central banks between trying to strengthen banks’ liquidity and reserves and trying to stimulate bank lending? Explain.
  7. Why are “the ECB’s policies likely to destroy half of Germany’s 1500 savings and co-operative banks over the next five years”? (See the Telegraph article.
  8. What are the disadvantages of quantitative easing?
  9. What are the arguments for and against backing up monetary policy with expansionary fiscal policy? Consider different forms that this fiscal policy might take.
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Chinese monetary policy

In recent months the Chinese central bank (the People’s Bank of China) has taken a number of measures to boost aggregate demand and arrest the slowing economic growth rate. Such measures have included quantitative easing, cuts in interest rates, a devaluation of the yuan and daily injections of liquidity through open-market operations. It has now announced that from 1 March it will reduce the reserve requirement ratio (RRR) for banks by a half percentage point.

The RRR is the percentage of liabilities that banks are required to hold in the form of cash reserves – money that could otherwise have been used for lending. This latest move will bring the compulsory ratio for the larger banks down from 17.5% to 17%. This may sound like only a small reduction, but it will release some ¥650bn to ¥690bn (around $100bn) of reserves that can be used for lending.

The cut from 17.5% to 17% is the fourth this year. Throughout 2014 and 2015 it was stable at 20%.

The hope is that this lending will not only help to boost economic growth but also stimulate demand for the consumption of services. The measure can thus be seen as part of a broader strategy as the authorities seek to re-balance the economy away from its reliance on basic manufacturing towards a more diversified economy. It is also hoped that the extra demand will help to boost jobs and thus provide more opportunities for people laid off from traditional manufacturing industries.

It is expected that further reductions in the RRR will be announced later in the year – perhaps a further 1.5 to 2 percentage points.

But what will be the effect of the releasing of reserves? Will the boost be confined to $100bn or will there be a money multiplier effect? It is certainly hoped by the authorities that this will stimulate the process of credit creation. But how much credit is created depends not just on banks’ willingness to lend, but also on the demand for credit. And that depends very much on expectations about future rates of economic growth.

One issue that concerns both the Chinese and overseas competitors is the effect of the measure on the exchange rate. By increasing the money supply, the measure will put downward pressure on the exchange rate as it will boost the demand for imports.

The Chinese authorities have been intervening in the foreign exchange market to arrest a fall in the yuan (¥) because of worries about capital outflows from China. The yuan was devalued by 2.9% in August 2015 from approximately ¥1 = ¢16.11 to approximately ¥1 = ¢15.64 (see chart) and after a modest rally in November 2015 it began falling again, with the Chinese authorities being unwilling to support it at the November rate. By January 2016, it had fallen a further 2.8% to approximately ¢15.20 (click here for a PowerPoint file of the chart).

But despite the possible downward pressure on the yuan from the cut in the reserve requirement, it will probably put less downward pressure than a cut in interest rates. This is because an interest rate cut has a bigger effect on capital outflows as it directly reduces the return on deposits in China. The central bank had already cut its benchmark 1-year lending rate from 6% to 4.35% between November 2014 and October 2015 and seems reluctant at the current time to cut it further.

China central bank resumes easing cycle to cushion reform pain Reuters, Pete Sweeney (29/2/16)
China cuts reserve requirements for banks to boost economy PressTV (29/2/16)
China Moves to Bolster Lending by Easing Banks’ Reserve Ratio New York Times, Neil Gough (29/2/16)
Economists React: China’s ‘Surprise’ Bank Reserve Cut Wall Street Journal (29/2/16)
China Cuts Banks’ Reserve Requirement Ratio Bloomberg, Enda Curran (29/2/16)
China Reserve-Ratio Cut Signals Growth Is Priority Over Yuan Bloomberg, Andrew Lynch (29/2/16)
China reserve ratio cut not a signal of impending large-scale stimulus: Xinhua Reuters, Samuel Shen and John Ruwitch (2/3/16)
China injects cash to boost growth and counter capital outflows Financial Times, Gabriel Wildau (29/2/16)
China’s Economic Policy Akin To Pushing On A String Seeking Alpha, Bruce Wilds (2/3/16)
China cuts banks’ reserve ratio for fifth time in a year: Why and what’s next Channel NewsAsia, Tang See Kit, (1/3/16)


  1. Explain what is mean by the required reserve ratio (RRR).
  2. Explain how credit creation takes place.
  3. What will determine the amount of credit creation that will take place as a result of the $100bn of reserves in Chinese banks released for lending by the cut in the RRR from 17.5% to 17%.
  4. What prompted the recent cuts in the RRR?
  5. Why may China’s recent monetary policy measures be like pushing on a string?
  6. Is the reduction in the RRR a purely demand-side measure, or will it have supply-side consequences?
  7. Explain how different types of monetary policy affect the exchange rate.
  8. Should other countries welcome the cut in China’s RRR? Explain.
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Japan’s deflation fears grow (update)

In the blog Japan’s interesting monetary policy as deflation fears grow we detailed the aggressive monetary measures of Japan’s central bank to prevent a deflationary mindset becoming again established. In January it introduced a negative interest rate on some deposits placed with it by commercial banks. This is in addition to it massive quantitative easing programme to boost the country’s money supply. Despite this, the latest consumer price inflation data show inflation now running at zero per cent.

As the chart shows, since the mid 1990s there have been protracted periods of Japanese price deflation (click here to download a PowerPoint file of the chart). In January 2013 Japan introduced a 2 per cent CPI inflation target. This was accompanied by a massive expansion of its quantitative easing programme, through purchases of government bonds from investors.

Following this substantial monetary loosening, buoyed too by a loosening of fiscal policy, the rate of inflation rose. It reached 3.7 per cent in May 2014.

However, through 2015 the rate of inflation began to fall sharply, partly the result of falling commodity prices, especially oil. The latest inflation data show that the annual rate of CPI inflation in January 2016 fell to zero percent. In other words, consumer prices were on average at the levels seen in January 2015.

The latest inflation numbers appear give further credence to the fear of the Bank of Japan that deflation is set to return. The introduction of a negative deposit rate was the latest move to prevent deflation. As well as encouraging banks to lend, the move is intended to affect expectations of inflation. By adopting such an aggressive monetary stance the central bank is looking to prevent a deflationary mindset becoming re-established. Hence, by increasing the expectations of the inflation rate and by raising wage demands the inflation rate will rise.

The loosening of monetary policy through a negative interest rate follows the acceleration of the quantitative easing programme announced in October 2015 to conduct Open Market Operations so as to increase the monetary base annually by ¥80 trillion.

The decline of Japan’s inflation rate to zero may yet mean that further monetary loosening might be called for. Eradicating a deflationary mindset is proving incredibly difficult. Where next for Japan’s monetary authorities?

Consumer Price Index Statistics Bureau of Japan

New Articles
Japan’s inflation drops to zero in January MarketWatch, Takashi Nakamichi (25/2/16)
Japan inflation falls back to zero in January: govt AFP (26/2/16)
With pause in inflation, many brace for retreat Nikkei Asian Review (27/2/16)
Japan’s inflation rate has fallen again – to 0% Business Insider Australia, David Scutt (26/2/16)

Previous Articles
Bank of Japan adopts negative interest rate policy CNBC, Nyshka Chandran (29/1/16)
Japan adopts negative interest rate in surprise move BBC News (29/1/16)
Bank of Japan shocks markets by adopting negative interest rates The Guardian, Justin McCurry (29/1/16)
Japan stuns markets by slashing interests rates into negative territory The Telegraph, Mehreen Khan (29/1/16)
Japan introduces negative interest rate to boost economy The Herald, (29/1/16)


  1. What is deflation?
  2. What are the dangers of deflation? Why is the Bank of Japan keen to avoid expectations of deflation becoming re-established?
  3. To what extent are national policy-makers able to exert pressure over the rate of inflation?
  4. What does a negative interest rate on deposits mean for depositors?
  5. What effect is the Bank of Japan hoping that a negative deposit rate will have on the Japanese economy? How would such effects be expected to occur?
  6. What effect might the Bank of Japan’s actions be expected to have on the structure of interest rates in the economy?
  7. How might the negative interest rate effect how people wish to hold their wealth?
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OECD goes public

In an attempt to prevent recession following the financial crisis of 2007–8, many countries adopted both expansionary monetary policy and expansionary fiscal policy – and with some success. It is likely that the recession would have been much deeper without such policies

But with growing public-sector deficits caused by the higher government expenditure and sluggish growth in tax receipts, many governments soon abandoned expansionary fiscal policy and relied on a mix of loose monetary policy (with ultra low interest rates and quantitative easing) but tight fiscal policy in an attempt to claw down the deficits.

But such ‘austerity’ policies made it much harder for loose monetary policy to boost aggregate demand. The problem was made worse by the attempt of both banks and individuals to ‘repair’ their balance sheets. In other words banks became more cautious about lending, seeking to build up reserves; and many individuals sought to reduce their debts by cutting down on spending. Both consumer spending and investment were slow to grow.

And yet government and central banks, despite the arguments of Keynesians, were reluctant to abandon their reliance solely on monetary policy as a means of boosting aggregate demand. But gradually, influential international institutions, such as the IMF (see also) and World Bank, have been arguing for an easing of austerity fiscal policies.

The latest international institution to take a distinctly more Keynesian stance has been the Organisation for Economic Co-operation and Development (OECD). In its November 2015 Economic Outlook it had advocated some use of public-sector investment (see What to do about slowing global growth?. But in its Interim Economic Outlook of February 2016, it goes much further. It argues that urgent action is needed to boost economic growth and that this should include co-ordinated fiscal policy. In introducing the report, Catherine L Mann, the OECD’s Chief Economist stated that:

“Across the board there are lower interest rates, except for the United States. It allows the authorities to undertake a fiscal action at very very low cost. So we did an exercise of what this fiscal action might look like and how it can contribute to global growth, but also maintain fiscal sustainability, because this is an essential ingredient in the longer term as well.

So we did an experiment of a two-year increase in public investment of half a percentage point of GDP per annum undertaken by all OECD countries. This is an important feature: it’s everybody doing it together – it’s a collective action, because it’s global growth that is at risk here – our downgrades [in growth forecasts] were across the board – they were not just centred on a couple of countries.

So what is the effect on GDP of a collective fiscal action of a half a percentage point of GDP [increase] in public investment in [high] quality projects. In the United States, the euro area, Canada and the UK, who are all contributors to this exercise, the increase in GDP is greater than the half percentage point [increase] in public expenditure that was undertaken. Even if other countries don’t undertake any fiscal expansion, they still get substantial increases in their growth rates…

Debt to GDP in fact falls. This is because the GDP effect of quality fiscal stimulus is significant enough to raise GDP (the denominator in the debt to GDP ratio), so that the overall fiscal sustainability [debt to GDP] improves.”

What is being argued is that co-ordinated fiscal policy targeted on high quality infrastructure spending will have a multiplier effect on GDP. What is more, the faster growth in GDP should outstrip the growth in government expenditure, thereby allowing debt/GDP ratios to fall, not rise.

This is a traditional Keynesian approach to tackling sluggish growth, but accompanied by a call for structural reforms to reduce inefficiency and waste and improve the supply-side of the economy.

Osborne urged to spend more on infrastructure by OECD Independent, Ben Chu (18/2/16)
OECD blasts reform fatigue, downgrades growth and calls for more rate cuts Financial Review (Australia), Jacob Greber (18/2/16)
OECD calls for less austerity and more public investment The Guardian, Larry Elliott (18/2/15)
What’s holding back the world economy? The Guardian, Joseph Stiglitz and Hamid Rashid (8/2/16)
OECD calls for urgent action to combat flagging growth Financial Times, Emily Cadman (18/2/16)
Central bankers on the defensive as weird policy becomes even weirder The Guardian, Larry Elliott (21/2/16)
Keynes helped us through the crisis – but he’s still out of favour The Guardian, Larry Elliott (7/2/16)
G20 communique says monetary policy alone cannot bring balanced growth
Reuters (27/2/15)

OECD publications
Global Economic Outlook and Interim Economic Outlook OECD, Catherine L Mann (18/2/16)
Interim Economic Outlook OECD (18/2/16)


  1. Draw an AD/AS diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on GDP and prices.
  2. Draw a Keynesian 45° line diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on actual and potential GDP.
  3. Why might an individual country benefit more from a co-ordinated expansionary fiscal policy of all OECD countries rather than being the only country to pursue such a policy?
  4. What determines the size of the multiplier effect of such policies?
  5. How might a new classical/neoliberal economist respond to the OECD’s recommendation?
  6. Why may monetary policy have ‘run out of steam’? Are there further monetary policy measures that could be adopted?
  7. Compare the relative effectiveness of increased government investment in infrastructure and tax cuts as alterative forms of expansionary fiscal policy.
  8. Should quantitative easing be directed at financing public-sector infrastructure projects? What are the benefits and problems of such a policy? (See the blog post People’s quantitative easing.)
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Japan’s interesting monetary stance as deflation fears grow

The perceived wisdom is that nominal interest rates have a lower zero bound. The Swedish central bank (the Ricksbank) has effectively been charging financial institutions to deposit money at the central bank since 2009. On 29 January 2016 the Central Bank of Japan also introduced a negative interest rate on deposits. The -0.1 per cent rate currently applies to a portion of the reserves held by financial institutions at the central bank. The move is another attempt to pump energy into a struggling economy.

As the chart shows, since the mid 1990s there have been protracted periods of Japanese price deflation. In January 2013 Japan introduced a 2 per cent CPI inflation target. This was accompanied by a massive expansion of its quantitative easing programme, principally through purchases of government bonds from investors. Following the monetary loosening, buoyed too by a loosening of fiscal policy, the rate of inflation rose. It reached 3.7 per cent in May 2014.

However, through 2015 the rate of inflation began to fall sharply, partly the result of falling commodity prices, especially oil. Now there appears to be an increasing fear at the Bank of Japan that deflation may be set to return. The introduction of a negative deposit rate is intended to prevent deflation. In particular by affecting expectations of inflation. The hope is to prevent a deflationary mindset becoming re-established.

The further loosening of monetary policy through a negative interest rate follows on the heels of an acceleration of quantitative easing last October. Back then, the Bank of Japan said that it would conduct Open Market Operations so that the monetary base would increase annually be ¥80 trillion. This was reaffirmed in its 29 January announcement. For an economy that has experienced four recessionary contractions since 2008 and with provisional estimates suggesting that it contracted by 0.4 per cent in the final quarter of 2015, it remains to be seen whether further monetary loosening might yet be called for.

Consumer Price Index Statistics Bureau of Japan

Bank of Japan adopts negative interest rate policy CNBC, Nyshka Chandran (29/1/16)
Japan adopts negative interest rate in surprise move BBC News (29/1/16)
Bank of Japan shocks markets by adopting negative interest rates Guardian, Justin McCurry (29/1/16)
Japan stuns markets by slashing interests rates into negative territory Telegraph, Mehreen Khan (29/1/16)
Japan introduces negative interest rate to boost economy The Herald, (29/1/16)


  1. What does a negative interest rate on deposits mean for depositors?
  2. What effect is the Bank of Japan hoping that a negative deposit rate will have on the Japanese economy? How would such effects be expected to occur?
  3. What effect might the Bank of Japan’s actions be expected to have on the structure of interest rates in the economy?
  4. How might the negative interest rate effect how people wish to hold their wealth?
  5. What are the dangers of deflation? Why is the Bank of Japan keen to avoid expectations of deflation becoming re-established?
  6. To what extent are national policy-makers able to exert pressure over the rate of inflation?
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Acquiring a taste for credit (again)

The Bank of England’s Money and Credit release on 1 Feb provides us with data up to the end of 2015 on lending by banks and building societies to the rest of the UK private sector. In this post we update our blog of 17 December 2015 – is Minsky right yet again? – to analyse the latest data on lending. The headline numbers show that the flow of lending (net of repayments) by banks and building societies to UK households in 2015 was £40.8 billion up from £29.9 billion in 2014 taking their amount of outstanding lending to households to £1.26 trillion. Was American economist Minsky (1919-1996) right to have argued that cycles in credit are inevitable?

Chart 1 shows the stocks of debt acquired by both households and private non-financial corporations from MFIs (Monetary Financial Institutions), i.e. deposit-taking institutions. The scale of debt accumulation in the late 1980s and again from the mid 1990s up to the financial crisis of the late 2000s is stark. At the start of 1980 the UK household sector had debts to MFIs of around £53 billion. By the start of 2009 this had hit £1.29 trillion. To put these figures into context this corresponds to an increase in indebtedness to MFIs from 25 per cent of GDP to 86 per cent of GDP.

The chart also shows the increase in indebtedness of private non-financial corporations which are effectively every day businesses. They saw their debts to MFIs rise from around £25 billion to over £500 billion which is equivalent to an increase from 12 per cent of GDP to 33 per cent of GDP. (Click here to download a PowerPoint of Chart 1.)

The path of debt at the start of the 2010s is consistent with a story of consolidation. Although the term is readily used in the context of the public sector and measures to reduce public-sector deficits the term is also relevant for the private sector. Financially-distressed households, private non-financial corporations and MFIs took steps to repair their balance sheets following the financial crisis. Indeed the term is synonymous with the idea of a balance sheet recession which some economists argue describe the late 2000s. The result was that the demand for and supply of additional credit waned. Debt accumulation largely ceased and, as we can see from Chart 1, debt numbers fell.

More recently the indebtedness to MFIs of households has started to edge up again, though, as yet, not for private non-financial corporations. From the end of the first quarter of 2013 to the end of 2015 household indebtedness to MFIs has increased by 7 per cent to £1.26 trillion.

Chart 2 focuses on flows rather than stocks. (Click here to download a PowerPoint of Chart 2.) It allows us to see the accumulation of new credit (i.e. less repayments of debt). What is even more apparent from this chart is the evidence of cycles in credit. The growth in new credit during the 2000s is stark as is the subsequent squeeze on credit that followed. Across 2006 net flows of credit from MFIs to households reached £106 billion while the peak for PNFCs was across 2007 when they reached £71 billion. Subsequently, net credit numbers crashed with negative numbers for PNFCs indicating net repayments to MFIs.

The size of the credit flows emanating from MFIs and the magnitude of the resulting credit cycles is even more stark when presented as percentages of GDP. The annual flow of credit to households in the late 1980s reached 9.4 per cent of GDP while that to PNFCs peaked at the end of the decade at 5.2 per cent of GDP. Meanwhile, across 2006 net credit to households reached 7.5 per cent of GDP while the peak of lending to PNFCs was in the 12-month period to the end of 2007 Q1 equivalent to 4.8 per cent of GDP. In 2015, credit from MFIs to households reached 2.2 per cent of GDP while that to PNFCs was a mere 0.2 per cent of GDP.

Of course, the key question now is the path of credit. Clearly flows of credit to households are again on the rise. In part, this is driven by the rebound in the UK housing market. But, significantly there has been a significant rise in flows of consumer credit, i.e. unsecured debt.

Chart 3 shows the flows of consumer credit to individuals (excluding student loans involving the Student Loans Company) from MFIs and other credit providers. Again, we see the marked evidence of cycles. Across 2015 these net consumer credit flows amounted to £14.5 billion, the highest annual figure since 2005. (Click here to download a PowerPoint of the chart.)

To put the current rise in consumer credit into context, the net flow of consumer credit to individuals as percentage of GDP across 2015 as a whole amounts to about 0.8 per cent of GDP. This is the highest figure since the second half of 2006. While it might be a little early to say that credit numbers are a cause for concern, they do need to be seen in the context of a still relatively highly indebted household sector. Policymakers will be keeping a keen eye on credit patterns and assessing whether we have again acquired a real appetite for credit.

Households put another £4.4 billion on credit cards and personal loans in December as debt rises at fastest pace in a decade, Rachel Rickard Straus (1/2/16)
One in four ‘living for the day’ as 700,000 more expected to default on debt Independent, Simon Read (2/1/16)
Surprise mortgage jump confounds expectations Independent, Russell Lynch (1/2/16)
U.K. consumer credit slows; mortgage approvals up MarketWatch, Jon Sindreu (1/2/16)
Family debt continues to rise – report BBC News (13/1/16)

Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database Bank of England


  1. How can the financial system affect the economy’s business cycle?
  2. What does it mean if households or firms are financially distressed? What responses might they take to this distress and what might the economic consequences be?
  3. How would you measure the net worth (or wealth) of an individual or a firm? What factors might affect their net worth?
  4. How might uncertainty affect spending and saving by households and businesses?
  5. What does it mean if bank lending is pro-cyclical?
  6. Why might lending be pro-cyclical?
  7. Are there measures that policymakers can take to reduce the likelihood that flows of credit become too excessive?
  8. What do you understand by a consolidation by the private sector? Discuss the possible macroeconomic effects of such a consolidation.
  9. What is meant by a balance sheet recession?
  10. How might the effect of attempts by a large number of individuals to improve their financial well-being differ from those when only a small numbers of individuals do so?
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