how money works

GOVERNMENT FINANCE AND PUBLIC MONEY 98 99
Managing state finance

NEED TO KNOW THE CASE FOR INDEPENDENT CENTRAL BANKS

❯❯Money supply The total amount Many central banks were made independent of the government in the early
of money circulating in a country, 2000s, although they are still required to be both transparent and accountable.
from currency to less liquid forms. The 2008 crash led some to question whether independent banks are desirable.

❯❯Central bank An institution that Pros Cons
provides financial services to the
government and commercial ❯❯Monetary policy can be more ❯❯Unelected banks cannot be
banks, implements monetary impartial as banks have no interest voted out, arguably making
policies, sets interest rates, and in maintaining electoral popularity. them less accountable.
controls money supply.
❯❯As they are unaffected by the ❯❯Central bank controls may not
❯❯Currency in circulation Money electoral cycle they can plan and be enough to avert financial
that is physically used to conduct implement long-term policies. crises without government aid.
transactions between customers
and businesses. ❯❯Independent banks have tended ❯❯Governments may blame banks
to maintain lower rates of inflation. for recessions, so eroding trust.

BORROWING “Monetary policy is not a panacea”

Ben Bernanke

INCOME TAX HOSPITALS AND SCHOOLS

POLICE, MILITARY, AND CIVIL SERVICE

OTHER FORMS OF TAX

KEY

OUTFLOWS
INFLOWS

The central bank

A central bank is the “bankers’ bank,” acting as guarantor for the rest
of the banking system by supplying extra funding when it’s needed.
Central banks play a critical role in setting a country’s monetary policy.

How it works fundamental to commercial NEED TO KNOW
banks’ ability to lend, the central
A central bank manages a country’s bank helps to set interest rates for ❯❯Reserve rate The interest rate
currency, money supply, and the entire economy. When the set by the central bank that all
interest rates, and holds central reserve rate rises or falls, interest commercial banks must pay to
bank reserves. Commercial banks rates on commercial bank loans do borrow central bank reserves.
rely on these central bank reserves the same. As with the supply and It is also known as the base rate.
to support their day-to-day demand of other commodities,
operations. By altering the amount when demand for reserve money ❯❯Open Market Operations The
of the reserves, and the cost of is high, its price (here the reserve buying or selling of securities by
borrowing from them (via the rate rate or base rate) rises. Conversely, the central bank on the open
of interest, known as the reserve when the demand for reserve market in order to influence
rate or base rate), central banks can money is low, its price falls. money supply.
assert control over the country’s
money supply. Central banks often focus on ❯❯ Inflation targeting A central
regulating other specific economic bank monetary policy in which
The base rate is usually the targets—most typically the rate of a specific target inflation rate is
cheapest rate of interest available inflation. They do this by meeting set and made public, with the
for its currency, and because preset, publicly displayed targets. intention of stabilizing prices.
central bank reserves are

LENDER OF LAST RESORT Monetary targets

Because banking contains an reserves, play the role of “lender of A central bank’s monetary policy
element of risk, the stability of the last resort.” When a failing bank objective is usually to deliver price
system depends on an institution presents too risky a prospect for stability (low inflation) and to support
that can provide protection to banks lenders, it can still rely on loans the government’s economic objectives.
threatened with failure. Central from the central bank. This provides Price stability has a role in achieving
banks, with their potentially a safeguard against financial collapse economic stability more generally, and
unlimited quantities of central that could damage the economy. in providing the right conditions for
sustainable growth. Central banks have
19 countries a range of strategies to achieve this.
One is to target the total amount of
in the European Union share money in the economy: the money
a single central bank: the supply. A second strategy is to target a
European Central Bank particular exchange rate by altering the
amount of currency in circulation to
affect the foreign exchange markets,
and a third is to target a particular
interest rate, as illustrated opposite.

100 101GOVERNMENT FINANCE AND PUBLIC MONEY
Managing state finance

Reserve rate Central bank Reserve rate
too high too low
The central bank creates and supplies reserve
Wdminehotmeenrnaeenystdh,tterfhaoreetrericsereishsneeitgrsrvh.ael bank money to commercial banks, giving it huge power rlcWoaetwenh,tefrtanhallletsbh.raeensdekermmveoainnnedteyfroiesrst

over the day-to-day workings of the banking
system. Usually, the central bank will try to
maintain its target interest rate by pumping
reserve money into or out of the banks. This
affects demand for reserve money and, therefore,
the price the central bank can charge commercial

banks to borrow—the reserve rate.

PUSHING RATE DOWN C ommercial bank reser ves PUSHING RATE UP
The central bank buys To increase the interest
securities from the The central bank pumps The central bank rate, it sells securities to
commercial banks, so more of its money into sucks reserve money commercial banks, so
increasing the amount commercial bank reserves, out of the system, reducing the quantity of
of central bank reserves lowering the interest rate bringing the base central bank reserves in
in the system. As more and bringing it back in line rate up and back in the system. As a result,
money is available, the with the target interest rate. line with its target. demand for money and
cost of borrowing—the the cost of borrowing it
interest rate—decreases. goes up.

TARGET RESERVE INTEREST RATE

THE CENTRAL BANK

Managing the NEED TO KNOW ❯❯Credit guidance A form of
monetary system cheaper lending by the central
❯❯Secondary market The forum in bank that is designed to meet wider
By raising or lowering its reserve which investors buy and sell bonds government objectives such as
rate of interest, a central bank can issued by the government. boosting key industries.
influence the size of commercial
banks’ reserves, and thus their ❯❯Inflation A general increase in ❯❯Reserve ratio The percentage of
borrowing and lending rates and prices and fall in the purchasing depositors’ balances that a bank
the amount of money in circulation. value of money. must keep as cash. The reserve ratio
This affects spending, and inflation, is set by the central bank.
because when interest rates are ❯❯The spread The difference
lower, saving is less and borrowing between the cheapest and the
more attractive, and when interest most expensive interest rate.
rates are higher, the opposite is true.

Increasing money in circulation

Lowering the reserve (base) rate of interest

The central bank can cut the reserve rate of interest to make it cheaper
for commercial banks to borrow from its reserves. The idea is that the
commercial banks will then in turn reduce their interest rates to the public.

Central bank Commercial banks General public Money supply

$ $

Lower interest $
rates paid $

$ More money
circulates
Lower interest rates make central Commercial banks’ Lower interest rates make
bank loans more affordable reserves increase loans more affordable

Open market operations: buying bonds

The central bank buys bonds on the open market using newly created
reserves. Investors’ deposits from the sale increase the amount of reserve
money in the open market, which leads to a lowering of the short-term rate.

Central bank Investors in Commercial banks General public Money supply
government bonds

$$

$ $
$ $

Central bank creates money Investors deposit their Commercial banks’ Lower interest rates make More money
reserves increase loans more affordable circulates
and buys bonds payments in commercial banks

102 103GOVERNMENT FINANCE AND PUBLIC MONEY
Managing state finance

CENTRAL BANK CONTROLS 1668

Credit guidance Open market operations the year that the
oldest central bank
The central bank’s control of The central bank buys and sells in the world, the
commercial banks’ licences helps bonds in the open market to affect Swedish Riksbank,
it to influence how those banks the short-term rates of interest. was established
lend. It can, for example, give them
incentives to offer very low interest Credit access
rates to important sectors of
the economy. The central bank can restrict
commercial banks’ access to credit,
for example by raising the amount of
deposits they must hold as reserves.

Decreasing money in circulation

Raising the reserve (base) rate of interest

The central bank can curtail commercial banks’ lending to the public by raising its
reserve rate of interest. This makes it more expensive for commercial banks to borrow
from central bank reserves. Commercial banks in turn raise interest rates for borrowers.

Central bank Commercial banks General public Money supply

$$$ $

Higher interest $ $
rates paid $

$ Less money
circulates
Higher interest rates make central Commercial banks’ Higher interest rates
bank loans more expensive reserves decrease make loans more expensive

Open market operations: selling bonds

The central bank sells bonds back to the market in exchange for money, causing
investors to make withdrawals to buy the bonds, lowering the amount of money
in the banking system. Commercial banks respond by raising interest rates.

Central bank Investors in Commercial banks General public Money supply
government bonds

$ $$$ $
$$
$
$

The central bank sells Investors withdraw money Commercial banks’ Higher interest rates Less money
bonds to investors from banks to buy bonds reserves decrease make loans more expensive circulates

Budget constraint

Governments have financial constraints just as individuals and
companies do. When spending exceeds income, the government
may need to borrow—or even print—money to cover the shortfall.

How it works COVERED SPENDINGThe
government
Governments need to pay for the public services they spends money on
provide and for any other financial commitments public services and
they may have. To do this they tax the population, other financial
and borrow money if additional funds are needed. commitments.
In extreme cases it is even possible for governments
to print their own cash. Each strategy has its own GOVERNMENT
costs—but printing money is so risky that it is very BUDGET
rarely used directly.

The difference between a government’s tax revenues
and its spending is known as its budget (or fiscal)
deficit. The budget deficit shows how much extra
money the government needs to borrow (or print) to
finance its spending. It is typical for some governments
to run a small budget deficit on an ongoing basis.

Spending and The rest repayme
the deficit government
needs to raise $
Ideally a government’s spending money in order to
commitments (inside the circle) meet its spending lic law and o
should be covered by tax revenue commitments. Inte rder
and other forms of income. Pubnts
However, when a proportion of Taxes
spending is not covered (budget $
deficit), the extra funding has to
be raised either from borrowing
or by printing additional money.
Small deficits can usually be dealt
with by borrowing alone, but if a
deficit grows too large, then the
government may find itself in
financial difficulties as it may need
to borrow increasing amounts
simply to keep up with existing
payments (see pp. 146–7).

104 105GOVERNMENT FINANCE AND PUBLIC MONEY
Managing state finance

When orrowing mo 75%
proposed B y
spending is greater P of GDP: Libya’s
than income, the ney budget deficit—
government may need the worst
to borrow or even FICIT in the world
print money.

WelBfarUe DGET DE $

rinting mone

Defense

HOW GOVERNMENTS RAISE MONEY

Governments can raise funds to meet their spending
commitments in three different ways. Each strategy
has advantages and disadvantages.

Housing and ❯❯Taxes Governments
he environm can levy taxes on
Healthcare what the population
Education earns and owns, and
on foreign trade.
Taxes are safe, but
unpopular.

t ent SAFE UNPOPULAR

❯❯Borrowing LOW INTEREST
Governments can POLITICAL PAYMENTS
borrow from their
own citizens—through RISK
pension funds for
example—or from
abroad. But loans
incur interest charges.

❯❯Printing money LOOKS HIGH
A government can EASY FINANCIAL RISK
print its own money.
This seemingly simple
solution is rare because
of the risks it entails
(see pp.144–5).

How tax works

Taxation is the main way in which governments raise revenue needed
to pay for public spending. Governments may tax the public directly
(for instance, through income tax) or indirectly (via VAT for example).

How it works Direct and indirect taxes

Governments have the unique People have to pay taxes on either their income, or on
privilege of being able to demand what they spend. Some typical taxes on an individual
that anyone in their country pay in the US are shown below.
taxes. These can be divided into
“direct” taxes, which are paid from DIRECT TAXES FICA tax 15.3%
earnings, either by people or
institutions, and “indirect” taxes, $ This tax is a combination of social security tax
which are paid for out of consumer (12.4%) and Medicare (2.9%), both half paid by
spending. Taxes can be levied as a the employer and half by the employee.
share of spending or income, or as
a flat rate. A progressive tax system
is one in which richer individuals
pay proportionately more tax.

Questions surrounding the level
of taxation are hotly debated. As a
result, levels of taxation, and laws
about who or what pays for which
taxes, vary significantly from
country to country.

Income tax

TAXES AND BEHAVIOR Income tax depends Net income
on the filing entity
Some taxes are designed to reduce (individual, corporation,
the amount of revenue that goods etc.) and the amount
earn. Because a newly-levied or declared.
increased tax on a product puts up
its price, that item becomes less Once taxes on earnings
attractive to buy. Where a product have been paid out, the
is harmful, higher taxes—such as on amount remaining is
cigarettes—can be a way to reduce
public consumption. In cases where $ called “net” income.
consumer behavior does not alter
much in response to higher pricing, NET INCOME
however, the extra tax is likely to
raise much more money. This can
make some taxes very appealing for
governments looking for revenues.

106 107GOVERNMENT FINANCE AND PUBLIC MONEY
Managing state finance

$21 trillion NEED TO KNOW

thought to be hidden ❯❯Tax return A document used
in tax havens abroad by individuals and businesses to
record income.
INDIRECT TAXES
❯❯Tax rate The amount at which an
Other variables $ individual or a company is taxed;
rates vary according to a person’s
There are a variety of taxes in the income or a company’s returns.
US, including capital gains, gifts,
imports, and much more. ❯❯International agreements
Contracts that act as a restraint
Excise tax on taxation, such as in stopping
import duties from being levied.
An indirect tax that applies to
specified goods, such as TAX EVASION AND
gasoline, or activities, like AVOIDANCE
highway usage by trucks.
Because tax systems vary so
Sales tax widely from country to country,
it is possible to exploit the
This tax is applied differences in international tax
at the state level rates in order to reduce the total
and varies by state. amount of tax due. This is termed
Not all states have tax “evasion” when it is done
sales tax. illegally, and tax “avoidance” when
performed legally, although in
$ practice the boundaries between
the two are blurred. Some
jurisdictions deliberately set very
low tax rates to attract investment;
some also provide secrecy around
the identity of those investing
there. This has led to accusations
that such areas are acting as “tax
havens.” This means that, instead
of providing a legitimate location
for economic activity, they are
allowing major corporations and
the very wealthy to avoid paying
taxes they should be paying.

TAX

Government
borrowing

Government borrowing is the main way that governments pay for any
spending that is not already covered by taxation. However, excessive
borrowing will result in high levels of government debt.

Borrowing Managing the debt

Governments typically borrow Governments keep a careful eye on
money by issuing bonds to their overall level of debt, since high
individuals and financial levels of debt mean greater interest
institutions in exchange for a repayments are necessary. Very
loan. The government will elevated levels of debt may become
then pay a fixed rate of impossible to repay if tax revenue
interest over a period of time proves insufficient to keep pace
to the investor, paying the with interest rates. Furthermore, a
bond back in full when heavily indebted country that investors
it reaches maturity. see as a risky prospect may find it
difficult to borrow enough to cover
day-to-day spending.

TAX Government funds

A typical government receives
most of its financing in the

form of taxes, but borrowing is
also often necessary in order
to meet planned expenditures.

Any borrowed money will
need to be repaid eventually
and so a significant portion of
the government’s budget is
reserved for debt payments.

108 109GOVERNMENT FINANCE AND PUBLIC MONEY
Managing state finance

How it works maintain spending, and continue to provide services
with the aim that debts will eventually be repaid with
Governments will often want to spend more than they tax revenue. Most governments run a deficit from time
earn in taxes. This may happen during a recession, to time, and may run one most of the time. If debts
when there is higher unemployment and therefore can be repaid, and interest payments are not large,
lower tax revenues. The gap between government this is not a problem, but there is a risk of default
tax revenue and what it spends is called the deficit. when repayment cannot keep pace with borrowing.
Governments borrow in order to cover the deficit,

“A national
debt, if it is
not excessive,
will be to us
a national
blessing”

Alexander Hamilton, first US
Secretary of the Treasury

Repaying the deficit Repayment

The higher the deficit, the more money of Any debt that a government takes on
a government’s budget is required in order must eventually be repaid, along with
to pay it off. Governments with a surplus interest on that debt. A certain level

can give more to their debt payments. of debt repayment must always be
maintained by the government
to avoid default or excess
interest incurred on
that debt.

Government default DANGER
OF DEFAULT
If a government fails or refuses to pay back a debt in full
it is said to have defaulted. This means that it is unable
to keep up repayments on some of the debt it owes.

Public debt

Public debt is the total amount of money owed by a country’s
government, and includes historic debt. Nations with big economies and
large tax-paying populations can carry more debt than those without.

How it works in one year, it will be in deficit. Any money it borrows
to cover this is then added to the public debt. When
The total amount borrowed by a country’s government the government spends less than it collects in taxes in
(and by its previous governments) is known as the a year, it has a “surplus,” which can be used to pay
public or national debt. This is generally calculated as down the debt. Inflation can also help reduce a debt
the total debt minus the government’s liquid assets. burden. A state that becomes unable to pay its debt is
Interest is due on this debt, and it can be substantial. said to “default,” and will find it hard to borrow again.
If a government spends more than it collects in taxes

Carrying debt DEBT

Governments usually repay debt using
taxes. The more money they raise, the
faster they can repay it. The larger
a country’s economy, the more debt
it can safely hold, since a bigger economy
can gather more taxes.

DEBT DEBT

Medium 31% Big economy
economy A larger economy,
A smaller of total global debt
economy can is owed by the US such as the US,
only support can safely carry a
lighter debts. larger debt, since it
has more capacity

to raise taxes.

110 111GOVERNMENT FINANCE AND PUBLIC MONEY
Managing state finance

GOVERNMENT DEBTS RISE IN WARTIME NEED TO KNOW

War imposes exceptional demands on government spending. Governments ❯❯Public/national/sovereign debt
typically finance this by borrowing money. The first ever government debts Total debt owed by a government.
were a direct result of borrowing to fund military campaigns.
❯❯Internal debts Money that
DEBT is borrowed from within a
government’s own country.

❯❯External debts Money that
is borrowed from abroad.

GOVERNMENT

INFLATION INFLATION

DEBT

DEBT DEBT

DEBT DEBT Inflation can
Weak reduce debt
Rising prices
economy reduce the value
A struggling
economy is of money,
lightening the
liable to weight of debt
default. repayment.

Accountability

Responsibility for economic policy is usually shared between a country’s
government and its central bank. By reporting their decisions to the public and
to democratic institutions, they can be made more accountable to the people.

How it works scrutinized. Before the 2008 crash, monetary policy
had been increasingly left to central banks. However,
Democratic countries typically insist that governments since then the policy and the banking system’s role in
report annually to their legislative bodies about it have been subject to more rigorous examination, and
taxation and spending plans for the next year. This taxation and spending plans now tend to dominate the
annual budget has become the central instrument of debate during national elections.
government fiscal policy, and its contents are widely

NEWS FISCAL IMPACT
Government policymakers take a
Media reports long-term perspective. To achieve
on budget the best economic outcomes,
central bank policymakers need
The media reports to be guided by this perspective.
on changes to the
government budget Legislative body
and how they will approves budget
affect the public.
A country’s legislative body,
typically an elected

parliament, will debate the
budget and potentially
make changes.

Public adjusts its Government draws
spending habits up a budget

Knowledge about the Typically an annual budget
budget may inform allocates spending across
decisions by households
and firms on spending different resources.
and saving money.

Auditors inspect $ MONETARY IMPACT
public finances Central bank decisions on
Many countries have monetary policy affect
an independent government spending due
body that inspects to the impact of interest
the government’s rates on employment and
financial decisions. inflation in particular.

112 113GOVERNMENT FINANCE AND PUBLIC MONEY
Managing state finance

TRANSPARENCY AND ACCOUNTABILITY IN CENTRAL BANKS

The current trend in many countries Transparency Accountability
is for an independent central bank.
It is essential that an autonomous ❯❯Increased openness is expected to ❯❯Rigorous standards of conduct
central bank is able to coordinate lead to better-informed decisions. for the central bank’s staff should
effectively with the government and lead to higher-quality decisions.
keep it, and the public, appraised of ❯❯Political, economic, and procedural
plans and projections. To this end, a policies should all be clearly outlined. ❯❯Audited financial statements
central bank must demonstrate both should be made publicly available.
transparency and accountability. ❯❯Regular and comprehensive
reports must be made available ❯❯Operating expenses and revenue
to the public and the government. should be disclosed.

EXTERNAL FACTORS Central bank also oversees
Central bank decision-making commercial banks Oversight
must also take into account factors of commercial banks gives the
such as social attitudes, business central bank large power in
considerations, and the volatility shaping the economy.
of the financial markets.

Central bank sets Report justifies and Impact of
interest rates explains decisions policy is
monitored
Having consulted a range of The central bank governor and quantified
financial indicators, the central appears before the
bank decides on a target rate Financial institutions
committee to give further and the specialty
of interest. explanation when required.
press pay especially
Minutes of policy close attention to
meeting published the central bank’s

Reports of the central bank’s decisions.
decision-making process
are publicly available.

IMPACT ON THE PUBLIC IMPACT ON MONEY MARKETS
Interest rates affect saving, Interest rates affect the price of
borrowing, and spending financial assets and the exchange
decisions. These feed through into rate, which affect consumer and
output and employment, then business demand and the return
producers’ costs and prices, and on a country’s assets relative to
eventually consumer prices. their foreign-currency equivalents.

Attempting
control

Governments can attempt to manage the economy by adjusting policies such as
taxes and influencing interest rates. Each adjustment can affect a small part of the
complete economic machine. However, the economy is usually beyond the direct
control of a country’s government, and its different elements interact with each
other in different ways. Forecasting its behavior is difficult, and attempting to
balance competing demands for resources requires clear political judgment.

Economic machine INCOME Tax
Total earnings in
This design is based on a real machine, the economy. Total tax paid
the MONIAC, a hydraulic simulation to the government.
of the UK economy built in 1949 by See pp.126–127
economist Bill Phillips. Based on the
theory of national income, it showed DISPOSABLE Interest rates Quantitative
the connections between the different INCOME easing
parts of the economy using a system Earnings left Amount paid for
of tanks, pumps, and tubes, and could after taxes have borrowing money. Government-created
be used to make simple forecasts been paid. See pp.120–123 money. See pp.124–125
resulting from policy changes.
INVESTMENT
ECONOMIC INDICATORS Spending on
Each part of the machine has a reading investment by firms.
associated with it. In an actual
economy, the indicators these readings CONSUMPTION
represent are collected and produced EXPENDITURE
by the country’s national statistical Household income
bureau, generally using survey data to minus household savings.
assess levels of spending, employment,
and so on. One problem for the
government is the delay between
actual events in the economy, and
processing and receiving indicators.
See pp.116–119

114 115GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

NATIONAL INCOME ACCOUNTING $4.29
trillion
National income Income equals expenditure
Japan’s Gross National
National income is the total The idea of national income Income (GNI) in 2015
amount earned by every sector means that every penny spent
of the economy and from the in one part of the economy
foreign balance (also known must equate to a penny earned
as the balance of payments). elsewhere, and the total
National income accounting earnings of the economy must
is a method that a national match the total spending of the
government uses to measure the economy. This idea allows
level of a country’s economic economists to build models
activity in a given time period. such as the MONIAC machine.

DOMESTIC Imports
EXPENDITURE
Amount spent by Purchases from the
households, rest of the world.
government, and firms. See pp.136–137

GOVERNMENT Government FOREIGN BALANCE Exports
REVENUE spending Difference between
Amount taken by the exports and imports. Purchases by the
government in taxes. Amount spent by rest of the world.
the government. See pp.136–139
See pp.128–129

NATIONAL INCOME
Total earned by households,
firms, the government, and the
foreign balance.

Reading economic
indicators

Using a few key indicators of performance, governments can monitor
how parts of the economy are working and whether there are potential
problems ahead. However, such indicators must be read with care.

Measuring performance

Indicators are usually shown as the rate of change over
time, because the economy is very dynamic. But this
means indicators are only estimates, based on surveys
taken at a particular point in time.

Inflation Growth

This This is
is how measured by
quickly prices the growth of
are rising on “Gross Domestic
average. Inflation Product.” GDP is
is typically defined the total value of
according to the all of the goods and
percentage increase services produced
in price of a “basket by a country in
of goods,” which is one year.
selected by looking
at what products
people typically
buy over
a year.

116 117GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

How it works the employment and labor markets, and society in
general. The “headline indicators” generally relate
The main indicators governments use to monitor to parts of the economy that have the most impact
the economy are based on surveys of individuals, on people’s daily lives, and might include assessments
businesses, and government departments. A national of the likelihood that individuals will find employment,
statistics agency is usually charged with running the whether their pay will go up or down, and whether
survey, and then calculating the figures. The agency businesses will be able to expand.
will look at the economy, business, industry and trade,

1884 the year the US Bureau of Labor
Statistics was formed to analyze data

Unemployment Wages

This is the Overviews
proportion of of wages are
those who could usually shown
work and who as a growth figure.
want to work, but As prices rise due
are not currently to inflation, wages
employed. It is must rise even faster
measured as a in order to ensure
percentage and that living
varies widely standards are
across different improving.
countries.

Deciding on
economic policy

Governments closely monitor data on the economy to establish which
policies might improve its performance. There are numerous ways of
intervening, each with their own pros and cons.

Inflation With high inflation and low
unemployment, the government
TARGET VALUE raises taxes to reduce money in
the system and reduce inflation.

Unemployment Less money in circulation means lower
inflation but also encourages lay-offs,
Calibrating the
economic machine and unemployment rises.

Governments have a number of different controls they $
can adjust to help the smooth running of the economy.
The biggest are taxes, spending decisions, and interest Increasing tax
rates. Each of these controls affects the economy in
many different ways, and governments have to consider The government can try to slow
these when taking action. down the economy by raising
taxes, a measure taken when
“Inflation is the one inflation is a risk. An increase in
form of taxation taxes reduces spending. When
that can be imposed spending falls, suppliers are less
without legislation” likely to put up their prices, since
they risk losing a market, and
Milton Friedman inflation therefore slows. Cutting
taxes has the opposite effect.

118 119GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

How it works inflation and unemployment, with low unemployment
coming at the cost of high inflation, and vice versa (see
Economic policy making has been compared to trying pp.132–135). More recently, economists have concluded
to operate a finely balanced machine. By adjusting that economies run best by themselves, with limited
various policy “dials," the government aims for the intervention. Other institutions have control over policy,
best combination of key economic variables—usually, while the state concentrates on “supply-side policies,"
a combination of low inflation and unemployment levels. such as making markets more efficient.
However, economists point to a trade-off between

To reduce unemployment, the With unemployment low, the
government increases spending in government raises interest rates,
areas such as infrastructure to increase increasing the cost of borrowing and
the number of construction jobs. reducing the amount of money in
circulation to try and lower inflation.

Higher spending pumps money into
the economy, raising inflation.

Increasing spending $

When the economy slows Raising interest rates
down and there is a risk of rising
unemployment, the government A government that directly controls
can try to stimulate the economy the central bank (see pp.100–103)
by increasing spending. By can try and move interest rates.
encouraging public spending, When interest rates rise, borrowing
the state increases the likelihood becomes more expensive, leading
of firms employing more people people to spend less money, and
to meet the extra demand. Cutting businesses may feel pressure to
spending has the opposite effect. reduce their prices, thereby
lowering inflation. Cutting interest
rates has the opposite effect.

Interest rates

Interest is effectively the price charged by a lender to a borrower for
the use of funds. The national reserve interest rate, set by the central
bank, affects how easy it is to borrow or lend money in a country.

How it works made if the money had been invested elsewhere.
Interest charges with banks and other financial or
Lenders charge interest on the money or other assets business institutions are normally calculated as a
that they loan. This is a charge levied to cover risks to percentage of the borrowed amount and expressed
the lender, should the borrower fail to repay the loan. as a yearly figure—the annual percentage rate or
Borrowers perceived to present a greater risk of failing APR (see p.210). In the US, the Fed plays a key role
to repay a loan may be charged more. Interest charges in setting national interest rates (see pp.100–103).
also compensate lenders for profits that they may have

How interest rates are set

The base rate of interest is set by a country’s central bank in response to inflation
targets set by its government. Commercial banks respond to changes in the base
rate by adjusting the interest rates of the different products that they offer.

% Base rate

Government Central bank Raising the base rate
means that commercial
Each year, the government sets out The government’s inflation target banks pay higher interest
its goals for economic growth and is noted by the central bank, who on money they borrow from
rates of employment. One such then sets the base rate—the interest the central bank, making it
aim is to achieve price stability, as rate that the central bank charges more expensive for them to
this makes for stable economic commercial banks to borrow from borrow. Lowering the base rate
growth. Prices are kept steady when it. The central bank does this in means that commercial banks
inflation occurs at a limited rate, order to encourage commercial pay less interest on reserves
so the government sets an inflation banks to adjust their rates in line they borrow from the central
target, beyond which prices should with the base rate, as bank rates bank, which makes their
not rise or fall. This is announced determine the ease with which
annually, expressed as a percentage customers and businesses can borrowing cheaper.
of the Consumer Price Index (CPI). borrow and so affects investment,
The CPI is the cost of a basket of spending, employment rates, and
representative goods bought by a wage levels in the wider economy.
household, measured periodically. This in turn influences the prices
The 2016 inflation target for the US, charged for products, which
Eurozone, and Japan was 2 percent. affects inflation (see pp.122–123).

120 121GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

HOW INFLATION AFFECTS INTEREST RATES NEED TO KNOW

Interest rates affect inflation and the loan is a product and the interest rate ❯❯Nominal rate An advertised
converse is also true: inflation affects the price paid for it, so if the value of interest rate, which does not factor
interest rates. Inflation is the decline money decreases, then commercial in the effect of inflation (or fees, or
of a currency's purchasing power banks may charge a higher interest the effect of compound interest).
due to an oversupply of money rate on their loans. Higher charges
(see pp.132–135). A limited supply will make borrowing more expensive, ❯❯Real rate Of particular interest to
of goods and services, along with resulting in fewer loans being taken investors, this rate takes inflation
an oversupply of money, means out. This may ultimately impact into account and is calculated by
that money devalues and more of spending, causing the money supply subtracting the inflation rate from
it is required to obtain products. A to fall, as well as the rate of inflation. the nominal rate.

% LOANS HAVE HIGHER Unsecured loans Unsecured loans
INTEREST RATES do not have
Commercial banks THAN SAVINGS/TYPICAL INTEREST RATES OFFERED BY COMMERCIAL BANKS CREDIT guarantors or
DEPOSITS CARDS assets to act as
Banks need to make a profit, so if collateral. This
the cost for them of borrowing 15% PERSONAL makes them
from the central bank increases LOAN riskier to lenders,
(as the base rate goes up), or the 10% who may charge
interbank lending rate increases, $ higher interest
they need to reflect this in the rates as a result.
interest rates that they charge
customers for borrowing. 4% Secured loans Secured loans
Commercial banks set interest 3% are backed by
rates according to their own needs 30-YEAR collateral, such
so some banks may choose not to .6% FIXED as property.
pass lower interest rates on to $ MORTGAGE Mortgages
customers taking out loans, while are secured by
other banks may offer a higher 15-YEAR houses. Banks do
interest rate on savings in order to FIXED not have to pass
attract new customers’ money. $ MORTGAGE base rate changes
on unless the
borrower has a
tracker mortgage
(see pp.214–215).

INTERBANK Banks lend to each Savings Interest paid out on savings
LENDING RATE other at a slightly higher is kept lower than the interest
rate than the base rate. rate charged on loans, so that
the bank can profit from the
difference between them.

INTEREST RATES

The impact of changing interest rates selective about whom they lend to. This impacts the
affordability of obtaining or repaying an existing loan,
If interest rates fluctuated all the time, the economy such as a mortgage. By contrast, a drop in interest
would become volatile. This is why the government rates is intended to cause an increase in spending,
and central bank work together to keep inflation and since borrowers are able to take out loans more
interest at stable rates. Every time the interest rate is cheaply. For those with mortgages tracking the base
changed, it sends a signal to society to either spend or rate, interest repayments will drop. At the same time,
save—and may also increase or decrease confidence savers will tend to spend or invest deposits that are
in the state of the economy. A rise in interest rates attracting little interest. While discouraging saving
encourages saving, since higher interest will be paid through very low interest rates might stimulate the
on money in savings accounts, and investments can economy, this can ultimately negatively impact
grow. Meanwhile, borrowing becomes less attractive long-term savings plans, such as pensions.
as interest repayments are steeper, and banks more

When interest rates $ Imports Unemployment
are raised increase rises
Import Exports
Higher interest rates make loans less prices fall
affordable, while high interest on fall
savings accounts encourages saving $$$
rather than spending. As spending
slows, so does the economy, with Value
demand for goods and services of currency Export
decreasing. This eventually affects increases prices rise
businesses and employment levels.

Economy % HOW THIS EFFECTS THE ECONOMY Investment Demand falls
expected to grow Central bank decreases due to overall in the
raises the base costly loans and
interest rate low confidence economy
Inflation falls
% Household
consumption 2
Commercial banks decreases, with
raise interest rates; less spending
loans become more and more saving
expensive, but savers
Companies may
are rewarded find they are less
0 TIME (YEARS) profitable as it gets
harder to find loans
and investors

1

122 123GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

NEGATIVE INTEREST RATE POLICY (NIRP) 40.5%

In some countries, the central bank discourage savers from hoarding Argentina’s rate
has experimented with cutting base cash. Commercial banks, however, of inflation in
interest rates to a negative figure, for usually tend to be reluctant to April 2016, the
instance, –0.01 percent. If this rate pass negative interest charges on world’s highest
is passed on by commercial banks, to customers, particularly small
it means that depositors must pay a businesses, as small depositors may
percentage of their deposit to the be driven to withdraw their savings as
bank. A central bank might impose a cash to avoid fees. Large depositors
negative interest rate to encourage will pay negative rates to gain security
spending and investment, and and a stable currency account.

When interest rates $$$ Imports EXCHANGE RATES
are lowered decrease
Import Exports Unemployment
Lower interest rates make it cheaper prices rise increase falls
to take out loans, and hence to spend
more money. Saving becomes less $
attractive as interest rates are low.
With more money in circulation, Value
demand for products and services of currency Export
rise, stimulating businesses and decreases prices fall
increasing employment.

Economy % HOW THIS EFFECTS THE ECONOMY Investment Demand rises INTEREST RATES
expected to Central bank increases due to overall in the
reduces the base cheap loans and
contract interest rate high confidence economy
Inflation rises
% Household CREDIT
consumption 2
Commercial banks increases with
reduce interest rates; more spending
loans are cheaper, but and less saving
saving becomes less
Companies may
rewarding become more
0 TIME (YEARS) profitable as loans
and investors are
easier to secure

1

Quantitative easing

Quantitative easing is a 21st-century strategy aimed at boosting
the economy. It uses central bank’s powers to create new money in an
effort to reduce interest rates and increase investment and spending.

How it works currency—which the central bank then uses to
buy government bonds or bonds from investors such
Governments use a number of tools to try to manage as banks or pension funds. The aim is to increase
the growth of the economy in a stable and balanced the liquidity of money in the economy which will in
way. One of their key tools is their influence, via central turn lower interest rates and make lending easier
banks, over interest rates. Lowering interest rates can and more attractive. This, in turn, should encourage
encourage financial institutions to lend more to businesses to invest and consumers to spend more,
businesses and individuals, which encourages those thus boosting the economy.
individuals and businesses to spend rather than to save.
QE is still very much a monetary policy experiment
In recent times, quantitative easing (QE) has been in progress. There are concerns that it could lead to an
used when economic activity is sluggish and there is a inflation problem, and its detractors point out that its
fear of deflation or recession. QE involves the creation benefits are felt only in selected sectors of the economy.
of new money—usually in the form of electronic

CENTRAL BANK How QE is supposed to work

Ideally, money passed on to banks should trickle down to
all sectors, leading to spending, which boosts the economy.

$$$

Central bank creates Central bank uses COMMERCIAL BANK
new money new money to buy
assets, increasing the
$$$ size of commercial
banks’ reserves.

Commercial banks
sell assets, usually
government bonds,

to the central banks.

124 125GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

DANGERS OF QUANTITATIVE EASING CASE STUDY

QE is a new strategy and its effects are hard to measure. There is still disagreement UK
about whether it can stimulate the economy without taking too many risks.
The UK began a QE program in
The economy may Inflation may occur Banks don’t always early 2009, after interest rates were
not respond as due to increased pass on the money cut to almost zero. Most of the new
expected even to very money supply, but it to businesses in need, money has been used to purchase
large amounts of new is unlikely to lead to but hoard it or invest government debt. The effects of QE
money being created. hyperinflation. it elsewhere. depend on what sellers do with the
money they receive from selling
assets, and what banks do with the
additional liquidity they obtain.
The Bank of England believes QE
has boosted growth, but at the cost
of higher inflation and increasing
inequality of wealth, as prices rise.

$3.5 trillion

spent on QE purchases by the US government

$ COMPANY

$ WIDER ECONOMY

COMPANY COMPANY

$$

INTEREST $
RATES
$
REDUCED
Increased reserves reduce
interest rates (see pp.101- Individuals and businesses Increased spending
101), leading individuals and use loans to buy goods and and business investment
businesses to borrow more. services and invest in boosts economic activity.
businesses.

The level of taxation

It is difficult for governments to establish how much tax to levy. Too
low, and the government cannot provide the services people want.
Too high, and people will be unwilling to pay the tax.

How it works Drinks with over 8g of sugar Uvena 11g Dextrozade
per 3½ ounces could be 9.9g
Governments can impose taxes on a person’s earnings, taxed at $.08 per can/
their buildings and homes, savings and investments, carton—or $.24 per liter.
pensions, inherited property, or on what they spend.
Most governments rely heavily on income taxes, Carib No Sug Fiasco Peppy Bro
usually with different proportionate levels for different Ginger Bull Nite 10.3g
levels of earnings. This makes the tax system fairer, 11g 10.6g 10.6g 10.6g
but introducing more complexity also increases the Ale
chances of tax avoidance. However, some taxes are 15.2g
levied in order to change behavior. By taxing
something viewed as bad, such as tobacco or alcohol, Drinks with 5-8g of sugar per
the government can help to persuade people to 3½ ounces could be taxed at
consume less of those things. $.06 per can/carton—or $.18
per liter.
Pigouvian taxes
7.5g Dr. Orango Lifta 5.1g Schmoozer
Standard economic theory says that if consuming a good or Cafteen Jones 6.5g 6.6g
service causes harm, a tax should be applied to it until the 6.3g
value of the tax matches the cost of the harm done. As shown
to the right, a government could impose a tax on sugar to
match the cost to public health services of obesity. In the US,
some states tax sugary drinks, but the percentage varies.

NEED TO KNOW Milk- and fruit-based drinks, Sea
teas, and coffees might not be Mist
❯❯Effective tax rate Many tax systems allow different taxed, regardless of sugar content. Juniper
“reliefs”—such as investment relief to encourage juice
investment. More than one tax may also be levied at Smooch Skydosh Monkey 13.6g 11g
once, for example income and corporation tax. As a 9.3g Frothacino Chai latte Honesto
result, the effective (average) tax rate may differ from smoothie
the headline (basic) rate. Chocolate 13.7g 13.8g
milk
❯❯Marginal tax rate Describes the additional tax paid
from undertaking a small amount of extra activity—for
example the extra tax paid in earning $1 more. Decisions
made “at the margin” influence the behavior of
individuals and businesses, such as whether it is worth
working longer hours.

❯❯Gray economy People who work for cash wages or
fees and do not declare their income, in order to avoid
paying tax.

126 127GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

THE LAFFER CURVE

The Laffer curve, named after US economist Arthur Laffer,

illustrates the idea that there is an optimum level of

taxation to maximize revenues. This is because at very

high rates of taxation, more people will be looking to

Unintended effects of tax avoid or reduce the tax than will pay it. So, although tax

revenues initially increase with rising tax rates, eventually

$$$ ❯❯Some US cities are assessing the they will decline. Controversy surrounds the idea because
tax by the ounce. This might it is very hard to know where this optimum point might
encourage people to drink less. be and also because it would seem to legitimize non-
payment of taxes by high net-worth individuals, and tax
❯❯Consumers may turn to sugary avoidance by ordinary people who start to participate in
untaxed drinks such as the “gray economy.”
milkshakes and smoothies.

❯❯The tax increase may hit poorer GOVERNMENT REVENUE
consumers harder, making it a
regressive tax.

❯❯Share prices and profits of drinks
companies may fall, affecting
government tax revenue.

❯❯If businesses are affected, this
may lead to the loss of jobs.

❯❯In Mexico, a 10 percent tax on TAX RATE
soft drinks has raised more than
$2 billion since 2014, but sales
have started to rise again after
an initial drop.

24%
estimated percentage
of economic activity
in Greece that went
undeclared and untaxed
in 2013

Government
spending and cuts

Governments today spend a large part of what an economy
produces, using taxes to prioritize political commitments and
potentially boosting their country’s economy in the process.

How it works

Modern governments are expected Typical government 25p%rMoegdraicmals
to pay for a range of services spending IpnatTeyrrmaenDsesetnfpetonsrst6e%216%%
that typically includes education,
healthcare, pensions, and welfare How a government spends money
payments. The electorate may also depends on its political priorities,
expect them to invest in roads, the size of the government relative
airports, water, electricity and gas to the economy, and its level of debt.
supply, and other infrastructure. For instance, Scandinavian countries
famously prioritize significant
However, governments cannot welfare spending. Government
simply spend whatever they want. spending can also boost the
Healthy tax revenues are dependent economy. By spending on
on a thriving economy. Most infrastructure, governments can
governments attempt to prioritize help to sustain economic activity.
their spending depending on their Funding scientific research aids
political commitments, setting an product invention, feeding into
annual budget to allocate spending economic growth, while spending
from taxes they expect to receive. on education can provide the
training to make a workforce
SPENDING VS CUTS more productive.

Government spending can directly $4.15
support the economy, such as trillion
expenditure on transportation and
communications. Scientific
research is often funded by the
government, and spending on
education helps to train workers.
Some governments also subsidize
and support key industries.
However, many governments since
the 2008 financial crash have tried
to cut their spending to reduce

their deficits (see pp.146–147). the United States federal
These decisions are controversial, government’s budget for 2017
as the long-term effects on the
economy are still unknown.

128 129GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

Social security 24% GOVERNMENT SPEND
RELATIVE TO ITS ECONOMY
Other 24%Education 3%
COUNTRYThe size of a government’s budget,
relative to its economy, can vary. Typically,
governments spend around 40 percent
of GDP. The graph below shows some of
the variation. South Korea’s government
spends 30 percent of GDP, but Denmark’s
spends 58 percent.

US
20%

SOUTH KOREA
30%

AUSTRALIA
36%

RUSSIA
39%

JAPAN
43%

GERMANY
45%

UK
45%

ITALY
51%

FRANCE
57%

DENMARK
58%

GREECE
61%

SIZE OF GOVERNMENT SPENDING
AS % OF TOTAL ECONOMY

How governments
provide for the future

Government spending can help to shape how an economy develops.
By investing in productive activities, as well as day-to-day items,
governments can help their economies to grow.

How it works railways, electricity and gas supplies, and roads.
Sometimes, governments will also invest in housing.
As well as providing services like education and
healthcare, governments also usually take Spending on this is government investment, and
responsibility for providing the buildings public appears as its “capital” spend in the national budget.
services use, and for essential infrastructure like It is equivalent to spending by private companies and

Government investment and returns $
$
Governments can invest in many different areas of $ $
economic activity. The returns, such as those below,
can benefit the government, or wider society. WATER, WASTE,
AND
$ $

TRANSPORT GAS AND
ELECTRICITY

FLOODING

$ $ $ $ $ $

$ $ $
$$ $$ $$

$
$
$

Returns to government Returns to government Returns to government

❯❯Direct Passenger fares ❯❯Direct Energy bills paid ❯❯Direct Utility bills paid

❯❯Short-term Tax on increased ❯❯Short-term Lower energy ❯❯Short-term Cheaper
spending near stations costs utility costs

❯❯Long-term New businesses ❯❯Long-term More investment ❯❯Longer-term Health and
move in in infrastructure by business environmental benefits

❯❯Indirect Economic growth ❯❯Indirect Economic growth ❯❯Indirect Growth of cities

130 131GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

individuals on things such as CAPITAL SPENDING AND BORROWING
machinery and buildings, and in
the same way the investment will To fund their capital spending, private investors to share in the
produce a return over its lifetime. governments (just like businesses) returns. In some cases this means full
Sometimes this return is paid will often borrow money. This means privatization, in which a government
directly (for instance in passenger adding to their overall debt, so allows a private firm to build and run
fares) and sometimes it appears governments concerned with cutting the investment outright. When this
indirectly (for instance in the debts will often look first at ways of is not possible or desirable, private
economic benefits of a new road, reducing capital spending. However, investment may take the form of a
helping businesses to trade and this means missing out on the returns deal between government and
resulting in more tax revenues). of an investment, so in order to lower private investors to split the costs,
Governments justify spending by the costs, many governments have risks, and profits of building and
showing the returns it will produce. used private funding. This allows the running the investment.

$ $ $
$ $ $
$ $ $

SOCIAL HOUSING SCIENCE AND
INNOVATION

SCHOOLS AND
EDUCATION

$ $ $ $ $ $

$ $ $
$$ $$ $$

$
$
$

Returns to government Returns to government Returns to government

❯❯Direct Rent from tenants ❯❯Direct None ❯❯Direct Revenue from research

❯❯Short-term Cheaper rents; ❯❯Short-term Public opinion ❯❯Short-term Tax revenues
less homelessness; more stable
society ❯❯Longer-term More ❯❯Longer-term New markets;
productive workforce; better investment in business
❯❯Longer-term Growing towns social cohesion
❯❯Indirect Faster economic
❯❯Indirect Economic growth ❯❯Indirect Economic growth growth

Inflation

The general increase of average prices in an economy, accompanied
by a decrease in the purchasing power of money, is called inflation.
This leads to a rise in the cost of living.

How it works and services, and of money, have a demand for goods exceeds the
major impact. There are two main company’s ability or willingness
Inflation is the year-on-year rise types of inflation: “cost-push” to provide them. Rather than
in general prices. This increase is and “demand-pull.” Cost-push increasing supply to match demand,
usually measured by the cost of a inflation is driven by rising costs to businesses instead raise their prices.
basket of representative household businesses, which are then passed This alone would not cause demand-
goods. As more money is needed to on to their customers. A business’s pull inflation, but if there is also an
buy the same goods and services, costs might go up for a number of oversupply of money in the economy,
the value of money decreases, and reasons, such as a rise in the price of consumers will continue to pay
day-to-day living becomes more a raw material or the need to raise elevated prices, increasing them
expensive. There are various factors the wages of employees. Demand- further—a case of too much money
that influence inflation, but changes pull inflation happens when a high chasing too few goods.
in the supply and demand of goods

Cost-push inflation $

Several factors can cause costs to rise. An increase in the price of a raw
material, for instance, can have a ripple effect, leading to a rise in prices
throughout the economy. Increased energy and transportation costs can
also push prices up. Higher salaries and taxes are other examples of expenses
that are ultimately passed on to customers in the form of rising prices.

Cost of raw materials increases
The availability of an essential
commodity, oil, becomes limited, raising
its price and the cost of transportation,
heating, and manufacture. This has an
immediate and widespread impact on
basic costs for businesses, particularly
those that require the commodity for
production, such as this car factory.

Cost of components increases

The rising price of oil increases

$ the costs involved in making the
components that are used to

manufacture cars, raising the

business’s production costs.

132 133GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

“Inflation is always and everywhere
a monetary phenomenon”

Milton Friedman

$

Price of product rises Rate of inflation accelerates

Manufacturers respond If the price of goods and

$ to higher production services increases across
costs by passing some the economy, a higher rate

of this on to customers. of inflation results.

Higher wages Indirect tax increase CAUSES OF COST-PUSH INFLATION
The employees demand The government raises
better pay, as it appears the sales tax on the car. Cost-push inflation is driven by a rise in running costs
that prices are rising. The The company offsets this for businesses. This can have a number of causes.
company agrees and their by passing the cost on
overall costs increase. to consumers. ❯❯Costs of raw materials Increases might be due to a
scarcity resulting from a natural disaster, or an artificial
NEED TO KNOW limit imposed by a monopoly—for instance, the oil
embargo in the 1970s, which tripled prices.
❯❯Nominal values Prices, wages, and other economic
variables that are not adjusted in order to take account ❯❯Labor costs Strikes, low unemployment—meaning that
of inflation. companies need to pay more in order to attract skilled
labor—strong unions, and staff expectation that general
❯❯Real values Figures adjusted for inflation and used prices will rise can all result in the company’s increasing
when looking at economic variables over a period of wages and shifting the cost to customers.
time to determine whether increases are influenced
by inflation or economic growth. ❯❯Exchange rates When a country’s currency drops
against a trading partner, more money is required to
purchase goods from abroad, which can cause inflation.

❯❯Indirect taxes A rise in excise taxes or other tax on a
product might be passed on to the customer.

INFLATION

Inflation and the velocity able to keep pace with demand— NEED TO KNOW
of money circulation there will be more money buying
fewer goods. This can happen if ❯❯Market power A company’s
It is not just the supply of money the economy expands too rapidly, capacity to raise a product’s price
that affects growth in an economy, perhaps due to a sudden increase by manipulating levels of supply,
but also the rate at which money in money supply as a result of demand, or both. Increased
changes hands. This is called the monetary policy. Companies market power due to a strong
“velocity” of money. It is a measure respond by raising their prices, brand may result in lower output.
of how many times a unit of money kickstarting demand-pull inflation.
has been used in transactions for ❯❯Effective demand This is an
goods and services over a period of However, a higher money supply indication of what consumers are
time. For instance, if the same unit may not necessarily result in an actually buying, dictated by their
of money, such as $1, is spent three increase in velocity. If confidence willingness to spend, available
times in one year in three separate in the economy is low, banks may income, and need.
transactions, the velocity of money limit loans, while individuals and
will be three. If the money supply businesses may hoard rather than ❯❯Latent demand This represents
increases rapidly, as well as the spend their money. If there is customers who have a desire to
velocity of money, the supply of less money pumping around an buy a product, rather than those
goods and services may not be economy, inflation reduces. making actual purchases.

Demand-pull inflation

In an expanding economy, a phone company experiences a sudden increase in
demand for their product. However, since the company’s resources are already at full
capacity, they cannot increase their supply. Instead, they raise their product’s price.

Demand rises Manufacture at maximum capacity Demand outstrips supply
With more money available in the The factory is already producing at Suppliers cannot increase
economy, there is a willingness to full capacity, with full employment. output in the short term so
spend more money on products in Without investment to increase consumer demand exceeds
general. This brand of mobile phone, a production, which takes time, the the number of products that
market leader, is particularly in demand. supplier is unable to produce more. can be supplied.

134 135GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

CAUSES OF DEMAND-PULL INFLATION

2% When an economy expands too rapidly, ❯❯Lower tax A decrease in direct or
or unsustainably, an excess money indirect taxes can increase income.
the US federal supply can cause customer demand
government’s to overtake the supply of goods and ❯❯Consumer confidence If consumers
target level of services. An increase in spending is and companies feel confident about
inflation caused by several factors. the future, they may spend money
they would otherwise have saved.
❯❯Monetary policy A cut in interest
rates leading to a relaxation of loan ❯❯Property prices High house prices
restrictions can increase money can cause home owners to feel more
supply, leading to more borrowing wealthy, increasing their willingness
and spending. to spend and thus their demand for
consumer goods.
❯❯Government spending Increased
investment and spending by the state ❯❯Rapid growth abroad High export
can expand the money supply, sales can increase the amount of
resulting in consumer activity. money flowing into the country, with
a ripple effect on inflation.

$ $
$
$
$

$
$ Prices increase Rising rate of inflation
With an increased money supply If consumer spending
Effective demand and high consumer confidence, increases generally
The rise in customer demand has an customers seem willing to pay across the economy,
impact on the product’s price, as it is more for a limited supply of the and businesses respond
an “effective demand”: customers have product, so the company increases by raising prices, rather
the income to meet a higher price its price. How high a price rises than output, then a higher
point and are willing to pay more for depends on consumer demand for rate of inflation will result.
a product they perceive as valuable. the product; if price elasticity of
demand is inelastic—the item is
something that customers need
and cannot do without—the price
point may be pushed higher.

Balance of
payments

A country’s balance of payments (BOP) is a record of its international COUNTRY
transactions over a set period of time. This record tracks goods,
services, and investment into, and out of, the country.

How it works International flow

A country’s balance of payments account provides A country’s balance of payments
a record of all of its international credits and debits. includes transactions by individuals,
Transactions that result in money flowing into a businesses, and the government.
country will appear as a credit, while transactions Tracking these transactions helps the
moving money out of the country will appear as government determine how much
a debit. The BOP account has three parts: money is coming into and leaving
the current account, which measures goods the country, and in which economic
and services; the capital account, which areas there is a deficit or surplus.
tracks the movement of capital and
nonfinancial assets; and the financial
account, a subdivision of the capital account,
which looks at investment.

In theory, a country’s BOP should total zero,
as each credit to the current account will
correspond with a debit to the capital account,
and vice versa. Realistically, as a result of
variations in accounting practices and exchange
rate fluctuations, this rarely happens.

THE THREE PARTS OF A BOP ACCOUNT

A balance of payments account ❯❯Unilateral or one-way transfers, COUNTRY’S BOP
is separated into three main such as foreign aid or gifts
accounts, each of which track CURRENT CAPITAL FINANCIAL
different types of international Capital account ACCOUNT ACCOUNT ACCOUNT
transactions into and out of
the country. The three main ❯❯Capital transfers, such as money Credit Debit Debit
accounts are, in turn, divided into transfers or assets of migrants +$2bn –$1bn –$1bn
subaccounts, to chart specific
areas of expenditure. ❯❯Nonproduced, nonfinancial TOTAL: 0
assets, such as natural resources
Current account and land

❯❯Raw materials and merchandise Financial account

❯❯Services, such as business, ❯❯Assets held abroad, such as bonds,
tourism, or transportation investment, and foreign currency

❯❯Income, including from property ❯❯Foreign-owned assets at home,
and shares including bonds, investment,
and local currency

136 137GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

Goods and PORT Current account REST OF
services THE WORLD
$3bn The current account is
mainly concerned with the EXPORT
international exchange of
Goods and
goods and services. services
$1bn
$3bn - $1bn = $2bn

IM

Money transfers Capital account Money transfers
and land and land
$1bn This account is chiefly for $2bn
recording the movement of
$
money and nonfinancial,
Currency and nonproductive assets.
stocks
$1bn $1bn - $2bn = $-1bn

Financial account $

This account monitors Currency and
international positions in stocks
local and foreign currency, $2bn
bonds, and investment.

$1bn - $2bn = $-1bn

$$ Zero $$

Current account Balance of payment Capital and
$2bn financial accounts
The sum of the “balance of
payment” should equal zero, –$2bn
but this rarely turns out to be

the case.

International currency
fluctuations

Exchange rates fluctuate according to supply and demand.
If one country has a stronger, more stable economy than its
trading partners, then its currency will be valued more highly.

How it works or news of increased investment $$
in manufacturing facilities. Four
A country’s economic conditions key economic factors—gross Weak currency
change from day to day, which is domestic production (GDP),
why exchange rates also fluctuate inflation, employment, and These economic factors—either
continuously. These currency interest rates—indicate how well by themselves or combined with
fluctuations are determined in a country’s economy is performing, each other—can trigger a fall in
foreign exchange markets around and determine its exchange rates. the value of a country’s currency.
the globe when currencies are
traded (a buyer selling one Political stability is also crucial. LOW INTEREST RATES
currency to buy another). If investors fear that a government Low rates encourage
is not capable of managing its domestic growth, but
Buyers base their trading country’s economy, they will lose
decisions primarily on the confidence, sell their investments % do not attract investors
performance of a country’s in that country, and exchange the
economy. They examine real- local currency for other currencies. to buy currency.
time data such as interest rates, This in effect pushes down the
and political and commercial value of the local currency by HIGH INFLATION
events that will affect economic increasing the supply of it and Inflation increases the cost
performance—such as elections, reducing the demand for it. $ of export goods, lowering
the crash of a financial institution,
demand for them and for
the exporter’s currency.

NEED TO KNOW Currency CLOSED FALLING GDP
fluctuations Shrinking production
❯❯Dovish A cautious government indicates that demand for
monetary policy that encourages The state of the economy in any a country’s exports, and so
lower interest rates. country will dictate whether its for its currency, has fallen.
currency will rise or fall against
❯❯Hawkish An aggressive other currencies. Interest rates, HIGH UNEMPLOYMENT
government monetary policy inflation, productivity, and Rising unemployment
that is likely to lead to higher employment will all have a may signal falling
interest rates. bearing on currency. Investor production and a lack
confidence also affects of competitiveness.
❯❯Capital flight The movement exchange rates—investors LOW CONFIDENCE
of money invested in one favor countries with a sound Nervous investors
country’s currency to another; political regime, efficient sell local currency
usually caused by a drop in infrastructure, educated and so depress the
investor confidence. workforce, and social stability. exchange rate.

138 139GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

$$ $5.3
trillion
Bank Strong currency
counteractions the typical
These factors signal a booming value of foreign
When a country’s economy, and boost demand exchange trades
central bank expects for the country’s currency as made each day
the currency’s value to well as increasing its value.
drop, it tries to shrink THE IMPORTANCE OF
the money supply. HIGH INTEREST RATES % RESERVE CURRENCY
Higher rates attract
Bank foreign investors and Reserve currency is a recognized safe
increase the value of foreign currency held by a country’s
INCREASING the currency. central bank and financial institutions
INTEREST RATES and used to make trade payments.
Increasing interest rates STABLE INFLATION $ Using the reserve currency avoids the
attracts investors to buy Stable or falling need to change payments into local
the country’s currency as inflation can help currency, minimizing the exchange-
they will be rewarded with to boost the value rate risk for both countries. Many
high rates of interest. of the local currency. central banks set a reserve ratio—the
percentage of domestic currency
SELLING FOREIGN RISING GDP that the bank must hold. The US dollar
RESERVES High production rates is the currency most commonly held in
Selling foreign reserves demonstrate demand reserves worldwide.
and retaining domestic for a country’s products,
currency increases and thus its currency. $
demand for the
domestic currency. LOW UNEMPLOYMENT VIP
Employment is linked
to GDP, indicating that
a country’s products
are in demand.
HIGH CONFIDENCE
Confidence in a
nation’s economy can
be enough to keep its
currency buoyant.

Managing state
pensions

Most governments use taxpayer money from current workers
to fund pensions for those who have retired. Some governments
invest taxpayer money to increase the overall pension fund.

How it works reach the age for Social Security. Measuring how well pension funds
Governments need to ensure there are likely to meet current and future
In most countries, it is the current is enough moneyto go around, a liabilities is key to the successful
working generation that is funding task that is all the more challenging management of state pensions.
the pensions of those who have because in most developed
reached retirement age, as well as countries the population is aging, Managing
the pensions of those who are due which means that fewer and fewer investments
to retire. This is the case in the US, workers will be funding the
where Social Security contributions pensions of an increasing In countries with sovereign wealth funds,
from current workers fund number of older people. the government invests taxpayers’
retirement benefits for those who
contributions to increase the available
Managing contributions money in the fund. Investment is usually in
core assets, which are less risky but can still
In some countries, such as Chile and Japan, and at a state level in the
US, pension managers invest the funds collected from taxpayers fluctuate. If stock markets rise, so do
with the aim of keeping the amount of available money high pension funds, and vice versa.
enough to meet predicted demand. In other countries, any surplus
in the pension fund (such as the National Insurance Fund in the INVECSOTMREENTS
UK) may be lent to the government, but in general it is simply used
to pay for the pensions of people who have already retired.

$ $ MONEY$
$ MARKET
Assets GOVERNMENT
CURRENT WORKERS EMPLOYEE $ BONDS
CONTRIBUTIONS $ STOCKS
can be increased
to meet shortfall. AND
$ SHARES

INFRASTRUCTURE ASSET INVESTMENTS

140 141GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

“A pension is nothing WARNING ❯❯Government priorities
more than deferred can influence the way pension
compensation” ❯❯Overinvestment in equity contributions are invested—not
(stocks and shares), which can necessarily in the best interests
Elizabeth Warren promise high returns, poses a of the pension pool
potential risk to any pension or its future ability to make
fund, and can be especially payments. In some countries,
damaging to state pension a percentage of pension
funds. Japan discovered this contributions are lent to the
after the nation’s Government government for other
Pension Investment Fund lost purposes, or invested in public
5.6 percent of its value in the projects such as housing.
third quarter of 2015 due to
stock market investments.

LIABILITIES
Payments to pensioners will
appear as a liability on the Measuring health
government balance sheet.
Demographics influence the Sufficient money must come in to the pension
amount of money needed fund to maintain or improve it. The fund’s
to meet this liability. For performance can be assessed in two ways:
example, if the population is
$ projected to live longer in ❯❯Funding level The amount of money in a pension
fund compared to the amount of pension that
$ old age, the amount needed needs to be paid out. This can be expressed as a
for future payments will rise. percentage or as a ratio (the assets divided by the
liabilities). A funding level of 100%, or a ratio above
$ 1, means that there will be enough money in the
pension fund to meet the payment obligations.
$ A funding level below 100%, or a ratio below 1,
means there is not enough.
$
$ ❯❯Deficit The difference between the liabilities and
Increased assets from assets in a pension fund—i.e. the shortfall between
investments $$$ the money coming in and the money due to be
paid out. This is also known as unfunded liability.
SOCIAL SECURITY
BENEFITS

Why governments
fail financially

It is possible for a government to fail financially, and there are two main ways this
can happen. The first is when it loses the ability to meet its obligations to repay
its debt, potentially leading to a default. The second is when it fails to reassure
the public that the value of its currency, or money itself, can still be trusted,
potentially leading to hyperinflation. Fundamentally both causes are due to a
loss of public trust. So, if a government cannot be trusted, it is more likely to fail.

GOVERNMENT Loss of public trust
and financial failure
DEBT DEBT
UNPAYABLE DEBTS When a government and the
The government DEBT DEFAULT OUTCOME institutions of government
cannot pay its debts The government lose trust through their own
and higher interest cannot keep incompetence, corruption, or
payments are up with debt as a result of losing a war, there
demanded by repayments. is a major crisis. To prevent
lenders who no It has to default, this loss of trust
longer trust it. failing to pay becoming disastrous,
back those who a democracy may
loaned it money. A seek to remove
its government.

GOVERNMENT
TRUST

THE REST OF THE ECONOMY

Uncontrollable debt and default

If a government has taken on excessive borrowing and
cannot repay its creditors, it may cut spending and raise
taxes, but if it cannot shift the burden, a default becomes
inevitable. See pp.146–147

142 143GOVERNMENT FINANCE AND PUBLIC MONEY
Why governments fail financially

6 THE IMPORTANCE OF TRUST

countries have never Gaining trust
defaulted on their
debt: New Zealand, Trust is critical to making money and for governments to work properly. It
Australia, Canada, is necessary for economic growth. If people do not believe a government’s
Thailand, Denmark, financial promises, it may lose control of the economy. Trust is hard to
and the US win, and usually comes from political stability over a period of time.

Losing trust

Governments can lose trust in many different ways. A weak government
might decide to issue more money to meet the demands made on it,
instead of raising taxes. A government unable to repay its own debts,
especially those owed to other countries, may decide that defaulting
on the debt is easier than trying to levy taxes to pay. In both cases,
trust in the government and its money will be undermined.

GOVERNMENT

PRINTING MONEY $$ $$$ $$$ $$$ $$$ $$$ $$$
A weak government
prints money instead
of collecting taxes.

$

OUTCOME $ LOSS OF TRUST
$ As money floods the economy,

B it becomes worth less and less until
confidence in it collapses completely
and hyperinflation sets in.

$ $
$
$ $
$
$
$

$ $
$
Hyperinflation

When a currency’s value falls sharply,
prices rise quickly and goods become
scarce. A government may print more
money to steady prices, but this
undermines trust. See pp.144–145

How governments fail:
hyperinflation

Public confidence in a country’s currency can collapse, resulting in
exceptionally high rates of inflation. These episodes of hyperinflation
are comparatively rare, but always very serious.

How it works public spending, printing money to pay for it instead.
Prices can thus rise very rapidly as citizens refuse to
Trust in the value of a currency is essential to maintain believe that money has any value, and so they demand
price stability in modern economies. Governments more of it in any sale. Governments can subsequently
therefore seek to control money supply in order to feel pressured to issue more and more money in order
prevent dramatic price fluctuations that could erode to keep the economy moving. When this happens,
trust. But when governments are weak or not trusted, hyperinflation sets in, and it can be very hard for
these controls can break down. A weak government, governments to regain control.
for example, may be unwilling to raise taxes to pay for

Case study: Hyperinflation in Germany, 1921–24

$ Germany experienced an infamous period of hyperinflation after World War I.

COLLAPSE IN TRUST

War debts

DM

Public services

DM

Reparations

DM
DM DM DM $
DM DM DM £€
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
DM DM DM
1. Following war defeat, Germany’s 2. The German government starts 3. By 1922, Germany cannot pay
new government is unstable. It using the money it prints to purchase reparations. France and Belgium
prints money to pay for war debts, foreign currency, causing a collapse in occupy the Ruhr to enforce payment
reparations, and public services. the value of the German mark. in goods instead of money.

OUT OUT OUT DM

4. German workers in the Ruhr 5. As the economy collapses, DM
go on strike. The government prints the German government
more money to pay their wages. continues to print money. DM

6. Domestic prices in Germany
explode as confidence in the
currency evaporates.

144GOVERNMENT FINANCE AND PUBLIC MONEY 145
Why governments fail financially
200,000,000,000
MARKS

HYPERINFLATION STOPPING HYPERINFLATION

Credibility

Because hyperinflation is based on expectations about the future, with
people believing prices will carry on rising rapidly, it can also be halted
rapidly (in theory). If the government can credibly commit to ending
inflation (for example, by introducing a new currency and tight rules on
issuing it), it can stop hyperinflation with limited costs. However, fulfilling
that commitment can be challenging, particularly for weak governments.

Dictatorship

One controversial argument is that because hyperinflation results from
weak governments, ending hyperinflation requires a strong
government—even one that ends democracy. Economist Thomas Sargent
has made this argument for central Europe in the 1920s, where a series of
hyperinflationary episodes were halted by authoritarian governments.

100,000 MARKS 460 septillion

10,000 MARKS the number of Hungarian pengö
to 1US$ at the height of
hyperinflation in July 1946

NEW GOVERNMENT

8. A new government is formed in November 1923, with a new
president of the German central bank. The central bank stops
paying government debts with printed money. A new currency,
the Rentenmark, is introduced, replacing the near-worthless paper
mark. The Rentenmark is backed by mortgages on land, while
the new central bank president promises to fix its exchange rate
against the dollar. These measures restore public confidence in
the currency. Some of Germany’s war debts are written off and
reparations reduced in 1924–25. The situation is stabilized.

DM
PRICE163 MARKS
RM
1922 TIME 1923

7. Hyperinflation sets in and prices $
rise faster than people can spend their
money. In 1922, a loaf of bread cost
163 marks—by November 1923 this
had risen to 200,000,000,000 marks.

How governments fail:
debt default

A government can find its debts spiraling out of control, as interest
payments rise faster than it can raise taxes. Once this happens, the
government is on the path to default.

How it works Argentina 1998−2001 Borrowing
increases
Ideally, government borrowing should remain stable. The debt spiral in which Argentina DEBT RISES
Sometimes, however, even a well-run government can found itself from 1998 until 2001
be hit by an unexpected and costly event, such as a resulted in what was the largest default
currency crisis or a sharp recession. When this in history at that time (it has since been
happens, the government may find itself borrowing dwarfed by the 2012 “restructuring” of
increasing amounts to try and keep up with interest Greece’s debt). Argentina owed a large
payments due on its existing debt. amount of money, and was borrowing
more from other countries and the
To alleviate this pressure, a government may International Monetary Fund (IMF),
increase taxes and cut public spending to bring in until a recession prevented it from
money. In practice this may mean government repaying its debts fully and
employees accepting payment as an IOU in lieu of cash, the country defaulted.
or a reduction in public services. If these measures fail, Recession
a government may eventually be forced to default on IMF World DEBT
the debt and admit that it cannot pay. Governments Bank US 6. The economic
that default on a debt will find it very difficult to borrow downturn in the
in the future, since trust in the country’s economic 1. Following a period country worsens.
stability will be low. However, countries that default on of hyperinflation during
their debts do sometimes recover very rapidly. the 1990s, Argentina
attempts to implement
INTEREST PAYMENTS IMF rules. It finds itself
having to borrow
Those lending money to countries will charge more if substantially from
they think the risk of a default is high, to compensate for official institutions
that risk. The danger for any country with large amounts such as the IMF, and
of debt is that this means a debt spiral can become a from other countries
self-fulfilling prophecy. As lenders lose confidence and such as the US.
demand more in interest payments, the debt becomes
more difficult to control, and default is more likely.

5. Argentina’s
government implements
austerity measures in an
attempt to cut costs.

146 147GOVERNMENT FINANCE AND PUBLIC MONEY
Why governments fail financially

€107 billion amount of Greek debt
written off in 2012

$ 7. Argentina’s Borrowing 9. The IMF 8. Argentina fails
repayments are increases withdraws to meet conditions
still too small to DEBT RISES its economic set out by the IMF
control rising support. on deficit targets.
levels of debt. 10. Argentina
11. The value of cannot repay its
3. Its repayments the currency $120 billion debt,
fail to bring debt plummets. and defaults.
under control. 13. A run on the
banks leads to Argentina
$ $a debt spiral the government defaults
$$ freezing deposits.
Borrowing 15. A period of 12. Argentinian
$ increases political instability unemployment
DEBT RISES sets in. reaches 20%.
2. Argentina
borrows heavily 14. Civil unrest
from elsewhere and rioting
in the world. break out.
DEBT
16. Agreements
$ on repayments
in 2002 help
Argentina enters4. The countries it has promote a boom.
borrowed from lose
faith in Argentina’s
ability to pay.

$$ $ $
$
$

$

$

$
$