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Bank of England and British Government

Introduction

The Bank of England serves the United Kingdom and acts as the central bank.  It was created 1694 in order to act as the banker to England, and currently is the banker to the UK government.  It has had its headquarters in London since 1734.  In 1946 it became state owned and has monopolised issuing banknotes in Wales and England.  The bank has a Monetary Policy Committee which manages the country’s monetary policy.  In cases where the there are adverse economic circumstances or public interest matters, the committee is given authority by the treasury and parliament to act as it deems fit to correct the situation.

The major function of the bank is supporting UK’s economic policies and maintaining stability in prices.  This is done by ensuring that there is monetary and financial stability.  Monetary stability is achieved by ensuring that the increases in price do not supersede the inflation targets of the government.  Financial stability on the other hand is achieved by timely neutralisation of the threats that face the financial system of the country.  Monetary and financial stability is achieved by the Bank of England through the use of policy instruments that stimulate the economic environment into achieving the desired results.  This is also done through cooperation with the Financial Services Authority and the Treasury.

The Bank of England has another function of issuing coins and notes, which  helps it control cash supply in UK’s economy.  Northern Irish and Scottish banks issue banknotes, though the notes require backing, according to Bank of England’s deposits.  The only currency that is not backed is some currency that represents value of notes circulating in 1845.  The notes are printed by De La Rue, a large firm that handles and prints bank notes internationally.

The bank also holds liabilities and assets, which include gold and foreign exchange.  The bank issues currency notes in exchange for assets that bear interest, for instance government bonds[1].  The bank generates income through difference in the monetary value of the currency and the interest rates received from assets. Most central banks hold other countries’ currency, especially if their currencies are stable.

The bank of England also acts as a last resort for banks that want to borrow money.  This happens when there are exceptional circumstances that make other banks decline or be unable to advance loans to other banks.  Such situations may arise due to unfavourable economic or political environments.  Finally, the Bank of England also manages the borrowing program for the government.

Success of the Bank of England and the British government in running British economy.

There have been mixed reactions on the success of the Bank of England and the British government in running the British economy over the last two years.  Some people see some level of success, while others feel that the two are no doing enough to protect the economy from adverse effects brought about by the mortgage crisis and high cost of fuel.  Most people are of the view that the moderate interference by the Bank of England and the British government, is not aggressive enough to protect the economy from these factors.

Some experts are of the view that the Bank of England and the British government have been too slow in mitigating the effects of the credit crisis in the US.  These experts compare the response by the US Federal Reserve to the crisis, with England’s, and they describe it as an inadequate reaction.  For instance, some say that the US Federal Reserve reduced interest rates by 3 points, from 5.25% to 2.25%, while the Bank of England lowered the same rates by 0.75%, due to fear of inflation.  This is seen as an inadequate response to this crisis.

They further say that Britain ranks as the top country with highest interest rates among the seven richest countries in the world.  This is seen to adversely affect the business and the housing market sectors of the economy. In fact, some businesses have complained of tightened loan terms which leads to suspension of investment decisions.  Other homeowners who were supposed to be charged fixed rates of interest on their mortgages are now facing the harsh reality of high mortgage payment.

When viewing the money market trends, interest rates for bank to bank transactions are 5.9%, which is higher than the official rate by a point. This clearly shows that the markets are anxious due to the mortgage crisis.  The experts advise the governor to be more aggressive in handling this issue.  This is because the market needs lower rates since business and personal lending depends on these rates.  Experts further attribute the increase in interest rates to lack of secure collateral by banks, compounded with the fact that borrowing is expensive.

Another flaw that the UK government is considered to have done, is to abolish the 10p starting rate of tax[2].  This was the lowest tax rate paid by individuals in the UK but it was abolished by Gordon Brown in 2007.  It had brought benefits to the people who earn lower incomes and encouraged them to get employment, through making work pay.

The policy also reduced poverty considerably, with some people estimating it to have helped about 12% of the poorest population.  It was also  estimated to have reduced the wealth of the richest population by more than 5%, which helped reduce income inequalities.  Parents and pensioners were helped the most, since pensioners are unable to work, and parents have to provide for their children.

The abolishing and subsequent attempts to mitigate the losses, by decreasing tax rates for basic rate band failed, since the benefits from the decrease in tax rates cancelled out with the loss from scrapping of the 10p tax rate.  Further attempts to correct the mistake, by proposing to review of minimum wage, winter fuel payments and tax credits for affected families, also failed due to bureaucracy in Government.  The scrapping of this policy affected workers without children and those people under 65 who relied on pension, since they could not qualify for the benefits.  The government finally admitted that ‘it could have handled the 10p tax rate issue better’, which does not help those who are suffering from scrapping of the policy.

The main macro economic policies used by the British government and the Bank of England over the last two years

The Bank of England is allowed to control the interest rates present in financial markets in order to prevent them from going above what is favourable for the economy.   The bank also has the responsibility of protecting investors and borrowers from unfair practices by banks, such as excessively increasing the interest rates, through controlling interest rates.  The central bank does this though lending or borrowing of money from commercial banks, in order to create artificial demand or supply.

In April this year, the Bank of England reduced interest rates by 0.25% in order to mitigate the effects of the credit crisis and near-inflation.  In fact, the IMF estimated that the current economic growth rate would decline by 1.4% up from 3% due to the credit crisis.  The inflation rate had increased to 2.5% during the last one year, which was also partly caused by the high fuel prices.  This intervention was necessitated by the slow pace of the housing market attributed to the credit crisis, which had the potential to slow down economic growth.

There are the many instruments that the Bank of England uses in order to ensure there is a stable macro economic environment[3].  The first tool is the open market operations, and this is a policy that the central bank uses when controlling the money supply in the economy of England.  This is done by buying and selling of securities, and in cases where the central bank wants to lower the money supply, it it sells the securities.

In case it wants to increase the money supply, the central bank buys securities.  This is achieved by printing more money to purchase the securities, which increases the money supply and decreases the securities in the economy.  Open market operations can also take the form of foreign exchange swaps, where the Bank of England purchases huge amounts of foreign currency in order to stabilise the local currency.

Another policy tool used by the Bank of England is the capital requirements.  This is the required rate that other banks are required by the central bank to hold hold their assets in proportion to capital.  In case the central bank wants to reduce the money supply in UK’s economy, it increases the required rate which forces banks to reduce the money in circulation.  In case the money supply needs to be reduced, the central bank reduces the required rate, which stimulates commercial banks into having more money for circulation.

Reserve requirements are yet another tool that the Central bank of England uses to regulate the amount of money that circulates in the UK economy.  This occurs when the central bank requires the commercial banks to hold a certain proportion of their liabilities as cash with them.  In cases where the Bank of England wants to reduce the amounts of money circulating in the UK economy, it increases the reserve requirement rate, which in turn stimulates the commercial banks to have less money in circulation, and vice versa.  This requirement is meant to prevent banks from lending very high amounts of money, which could lead to them suffering from bank runs.

The Bank of England may require that all or part of local currency be converted to foreign exchange.  This is also known as the foreign exchange swap and aims at strengthening the local currency against the foreign currency.  The bank may further set the exchange rate for currency in these circumstances or exchange them for the market rates.  This system is rarely used since UK’s currency is relatively stable and convertible, but due to the credit crunch, the bank of England entered into agreements with the Swiss Central and European Central banks, to use foreign currency.

Debt swaps are another tool that the Bank of England uses to mitigate the risks to the economy.  This is the exchange of debts owed by commercial banks with treasury bills, to mitigate the effects that the debts have on such banks.  The bank of England announced a plan, early this year to swap $100 billion worth of securities which are mortgage backed, in exchange for treasury bills.  This was done with an aim of encouraging lending practices for banks to resume, thus countering the US mortgage crisis.  Losses that are attributed to assets swapped were absorbed by the Bank of England and not passed to taxpayers.

 Conclusion and recommendation.

The British government and the Bank of England appear to be hesitant in mitigating the risks caused by the credit crunch.  This is a bad sign since it does not motivate investors, who are relying on the government and central bank to protect them from the adverse effects of the crunch.  The government should move with speed to reassure investors, since if they pull out their investments, the British economy will suffer.  The Bank of England on the other hand should influence the interest rates to go down, so that home owners may be able to afford to pay for their homes.  They can apply a combination of the instruments earlier discussed to bring down the interest rates.

The British government made a wrong decision in scrapping the 10p starting tax rate.  The damage can only be resolved by restitution of the affected people to their original state.  This can be achieved by giving working tax credit to those aged below 25, and also the people who work for less than thirty hours.  This will however be expensive, with some experts estimating it to cost £2.2 billion.  Another alternative would be to increase the working tax credit by 50% for the single people who are childless, which may cost close to £600 million.  In future, the government should carefully weigh the implications of decisions before making them.

Bibliography.

Davidson, A. How the City Really Works: The Definitive Guide to Money and Investing in London’s Square Mile. Kogan Page Publishers, 2008.

Disney, R. The abolition of the earnings rule for UK pensioners.  Journal of business. Retrieved on November 4, 2008 from <eprint.ucl.ac.uk> 2008.

OECD. OECD Economic Surveys: United Kingdom.  OECD Publishing. 2007.

[1]          Davidson, A. How the City Really Works: The Definitive Guide to Money and Investing in   London’s Square Mile. (Kogan Page Publishers, 2008), 46-58.

[2]          Disney, R. The abolition of the earnings rule for UK pensioners.  Journal of business. (Retrieved on November 4, 2008 from <eprint.ucl.ac.uk> 2008), 2-8.

[3]            OECD. OECD Economic Surveys: United Kingdom

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.  (OECD Publishing. 2007), 22-29.

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