The Bank of England Target Two Point Zero

The Times is running regular briefings to coincide with Target Two Point Zero, the Bank of England contest for sixth-formers run in conjunction with the newspaper.

The competition challenges students to play the role of the Bank’s Monetary Policy Committee (MPC) and recommend the best level for interest rates.

This week: as Gordon Brown finalises Wednesday’s Pre-Budget Report, we look at the effect of fiscal policy on the MPC’s task.

Why do decisions in Budgets and Pre-Budget Reports matter for setting monetary policy?

The winter Pre-Budget Report and the spring Budget frame government plans for tax and spending, which, with interest rates, are key to steering the economy.

Public spending is one of the key components of demand, while taxation subtracts from demand, slowing growth. Both the scale of tax, and the way in which it is levied, can affect the supply of goods, labour and capital. Other things being equal, increased public spending, or lower taxation, should imply higher base rates in future than would have otherwise been the case, and vice versa.

To what extent does the Treasury use tax and spending to steer the economy?

The Labour Government has largely rejected use of fiscal policy to fine-tune demand and growth in the short term, prefering to focus on medium-term aims, such as the effective delivery of services. However, the Treasury attempts to set tax and spending levels so that they act “in support” of monetary (interest-rate) policy. So the Chancellor tries to ensure that, when the economy is slowing and interest rates are being cut to stimulate activity, a looser fiscal policy (higher spending or lower tax) reinforces actions by the MPC. Conversely, when rates are being raised to restrain inflation, the Chancellor tries to avoid “throwing petrol on the fire” with too lax a “fiscal stance”.

How does the MPC assess the Chancellor’s announcements?

The MPC bases its evaluation on the Treasury’s published plans, which are presented in advance to the committee. MPC members will look for any significant change in the fiscal stance through potential pre-election giveaways, for example. They also consider any risks to the Treasury’s views.

How can the MPC gauge this?

The simplest measure of the fiscal stance is indicated by the change in government net borrowing, which reflects the balance between tax and spending. The Treasury believes that it is important to strip out the impact of the economic cycle and consider only discretionary changes.

What is happening to fiscal policy at present?

An ambitious spending drive intended to boost public services has seen spending climb at an average 4.8 per cent a year, in real terms, over four years. This is presently planned to slow to just 1.9 per cent from 2008 onwards. To pay for higher spending, taxes have been raised, while government borrowing remains substantially in the red. Much of the City thinks that Mr Brown may exceed his 2006-07 borrowing forecast of £36 billion.

Explore Economics

• Pre-Budget Report 2009

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