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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 promote economic stability and their own prosperity；
the most favourable way has been to peg the local currency to a major
convertible currency； such as the euro or US dollar。 This means that
while the local currency may move up and down against all other world
currencies； it will remain or at least a。。empt to remain stable against the
one it is pegged against。 In total； 22 states and territories have a national
currency that is directly pegged to the euro； including 14 West African
countries； 3 French Pacific territories； 2 African island countries and 3
Balkan countries。
。 Dollarized： This is a slight misnomer as the term is used to describe a
country that abandons its own currency and adopts the exclusive use
of the US dollar or another major international currency； such as the
euro。 The euro； for example； is the official currency in 15 states and
territories outside the European Union。 In such cases the country in
question takes on the risks and costs associated with