Monetary and Fiscal Policy

Later in term we cover these two things in detail - for now we just hint at them, and having looked at inflation in yesterday's lecture while thinking also about unemployment and yesterday's surprising GDP growth figures announced by the ONS, last night Mervyn King (Governer of Bank of England) made a speech in Newcastle about the UK economy.

In it he mentioned the problems he faces as the head of the Bank of England, which is in control of fighting inflation: He expects inflation to rise to 5% in 2011, yet the Bank's target is 2% (plus or minus 1% so a range of 1-3%). Yet GDP growth was negative in 2010Q4, and is not expected to perk up any time soon.

The problem is that high inflation would usually be met by the Bank of England with higher interest rates, yet growth is weak: And higher interest rates would hurt growth (we'll study the interest rate transmission channel from interest rates to economic activity later in term).

The fundamental problem is that of the two basic types of inflation covered yesterday, demand-pull and cost-push, the UK is suffering cost-push at the moment: The weak exchange rate imports inflation, and commodity prices are high at the moment - both factors that makes inputs more expensive.

However, as also mentioned, inflation can come simply from expectations becoming reality. If people start expecting higher inflation then they will attempt to build that into their wage settlements, particularly if and when the economy begins to recover. Then with more money in the economy, this will likely translate into higher actual inflation. So the current cost-push inflation may turn into demand-pull inflation, and this is what the Bank of England is seeking to avoid.

It seeks to avoid it precisely with speeches like this, attempting to show us that it knows what it is talking about when it comes to the economy...