how money works

248 249HOW MONEY WORKS
Index

capital risk 192, 193 how companies use debt 42–3 confidence in value of 97
capitalizing vs expensing 27, 30–31 and investment banks 74–5 digital 220, 221
Carter, Jimmy 240 issuing shares 182, 183 fiat 87, 220
cash 186 large-, medium- and small-cap 188 foreign exchange and trading 58–9
and money market 56–7 international currency fluctuations 138–9
advances 219 net income 28–9 representative 87
in bank accounts 174 pensions 196–7, 200 reserve 139
conversion 38, 39 share dividends 164–5 traditional 222
lump sums (pensions) 197, 202 shares 48–9 currency pairs 59
cash flow 26, 36–9 smoothing earnings 34–5 currency values 55
gap 39 United States and Canada 232–5 current accounts
management of 38–9 comparative advantage 21 balance of payments 136, 137
positive and negative 38–9 competitors 62 commercial banks 72, 73
central banks 100–103, 112 compound interest 208–9 credit unions 217
and banking reserves 90 Consumer Financial Protection Bureau nonbank financial institutions 83
and base rate 120, 122–3 cuts, vs spending 128
case for independent 99 (CFPB) 234
Federal Reserve Bank 240–41 Consumer Price Index (CPI) 120 D
and money supply 98, 99 consumption expenditure 114
and negative interest rate 123 consumption, government 97 Dalio, Ray 189
support for commercial banks 88 contingent liabilities 153 day trading 68–9
transparency and accountability 113 contractionary policy 93 dealers 61
certificate of deposit 57, 165 corporate advisory division (investment debasement 18
Chicago Stock Exchange (CHX) 233 debentures 163
children banks) 74, 75 debit cards 88, 204
cost of 152, 153, 162, 198, 199 corporate finance see company finance debt 204–19
savings 246 corporation tax 37, 126
China, economic slowdown 71 corporations 235 attitude to 157
claims, insurance 79 cost of living 132 credit cards 218–19, 244
Classical School 23 cost-push inflation 132–3 credit unions 216–17
coinage 12, 16–19 costs finance 41
“coins,” virtual 222, 223 and gearing ratio 40–41
collateral 180 as assets 30–31 government default 142–3, 146–7
college savings 246 property 170–71 government repayment 97, 108, 109
commercial banks 71, 72–3 coupons 50, 51 how companies use 42–3
and central banks 100–103, 113, 121, 124 credit access 103 interest and compound interest 208–9
interest rates 121 Credit CARD act 244 internal and external 111
lending 98 credit cards 18, 155, 204, 218–19 loans 210–11
loans 88, 89 charges 73 managing personal 151, 157
negative interest rates 123 debt 207 mortgages 212–15
reserve rates 90 fraud 219 and net worth 152–3
commercial loan providers 82 United States 244 public debt 110–11
commercial paper 57 credit checks 82 spirals 146–7
commercial property 178 credit crunch 92, 215 ways to borrow money 204–5
commodities 54 credit guidance 102, 103 and wealth 155
commodity-backed currency 87 credit limit 219 why we use debt 206–7
company finance credit money 88 debt-to-income ratio 242
bonds 50–51 credit rating/score 160, 177, 205, 207, 216, default 51, 109, 110, 111, 142, 146–7, 211
cash flow 36–9 deficit
corporate accounting 26–45 242 government 104, 109, 110, 128
corporate tax 235 credit report 176 pension funds 141
depreciation, amortization, and depletion credit unions 83, 205, 242 defined benefit pension plans 197, 198, 200
creditors 41, 43 defined contribution pension plans 198, 200
32–3 cross-selling 73 deleverage 41
derivatives 52–3 crowdfunding 83, 188, 220, 221, 226–7 demand-pull inflation 132, 134–5
expensing vs capitalizing 30–31 cryptocurrency 220, 222–5 demographics 141
financial reporting 44–5 currency 46
gearing ratio and risk 40–41
central banks 100
in circulation 86, 99
commodity-backed 87

INDEX

dependents’ accounts 246 efficient frontier 194–5 Federal Reserve System 234, 240
depletion 32–3 Einstein, Albert 209 Federation of Tax Administrators (FTA) 239
deposit (property) 176, 242, 243 elderly parents 199 fiat currency 87, 220
deposit accounts 56, 87, 166–7, 246 endowments 173 financial account (BOP) 136, 137
deposit liabilities 90 energy Financial Accounting Standards Board
depreciation 27, 29, 32–3
depression 94–5 cost of 132 (FASB) 234
derivatives 47, 52–3 government investment in 130 financial advisors 151, 187, 199, 200
digital money 13, 18, 220–29 Enron 35 Financial Conduct Authority 83
entry unit price 185 financial institutions 70–83
bitcoin 224–5 equipment 37
crowdfunding 226–7 equities 80 brokerages 76–7
cryptocurrency 222–3 over investment in 141 commercial and mortgage banks 72–3
peer-to-peer lending 228–9 equity insurance risk and regulation 78–9
tax on 247 finance 40 investment banks 74–5
dilution 41 home 180–81 investment companies 80–81
direct taxes 106, 135 property 213 nonbank financial institutions 82–3
discount brokers 76, 187 Eretheum 221 financial instruments 46–53
discount mortgages 215 estate tax 247 bonds 50–51
discount rate 240, 241 Euro 19 derivatives 52–3
disposable income 114 Euronext 55 shares 48–9
diversification 80, 169, 188–9 European Central Bank 100 financial markets 54–69
dividends excess (insurance) 79 arbitrage 64–5
commercial banks 72, 73 excess reserves 90 day trading 68–9
dividend cover 165 exchange rates foreign exchange and trading 58–9
investment banks 75 central banks and 100 manipulating the stock market 66–7
managed funds 185 and inflation 133 the money market 56–7
shareholders’ funds 45 international currency fluctuations 138–9 predicting market changes 62–3
shares 36, 38, 42, 43, 46, 48, 49, 68, 81, excise duty 107 primary and secondary markets 60–61
excise tax 236, 237 financial reporting 44–5
154, 158, 159, 164–5, 174, 175, 186 exit unit price 185 Financial Reporting & Assurance Standards
dollar (pound) cost averaging 187, 190–91 expansionary policy 93
domestic expenditure 115 expected return 195 (FRAS) 234
donations 37 expenses financial statements 35
double entry bookkeeping 88, 89 as assets 30–31 financing cash flow 39
Dow Jones Industrial Average (DJIA) 169, corporate 27, 29 fiscal policy 112
property 170–71 Fisher, Irving 22
233 expensing vs capitalizing 27, 30–31 fixed rate bonds 167
down payments 242, 243 exports 115, 135 fixed-rate mortgages 214, 242
drip-feeding money 187, 190 external debts 111 Floating Rate Notes (FRNs) 238
flotation 36, 48, 60, 61, 165
E F focus groups 159
Foreign Account Tax Compliance Act 235
early repayment charges 211 face value 50, 51 foreign balance 115
earnings 154, 156 factors 39 foreign exchange and trading 58–9
Federal Deposit Insurance Corporation foreign reserves 139
inflating 29 forex markets 58–9
per share 28, 29 (FDIC) 234, 240, 242 fourth markets 61
reported 31, 34 Federal Employee Identification Number fractional reserves 90–91
volatile 34 fraud
economic indicators 114, 116–17 (FEIN) 235
economic policy 118–19 federal funds rate 240 credit card 219
economic variables 119 Federal Housing Administration Short pension 203
economics, modern 20–21 prevention 234
education Refinance for Borrowers with Negative Friedman, Milton 23, 118, 133
costs 152, 155, 162, 199, 246 Equity 243 FTSE 100 76, 165, 169, 187
government investment in 131 Federal Insurance Contributions Act (FICA) FTSE All-share 169
effective demand 134, 135 245 Full Employment and Balanced Growth Act
effective tax rate 126 Federal Reserve Bank 239, 240–41
240
fund companies 187

250 251HOW MONEY WORKS
Index

fund managers 80–81, 169, 184 H and unemployment 118–19
fund supermarkets 187 infrastructure spending 128
fundamental analysis 62, 63 Hamilton, Alexander 109 inheritance tax 173, 247
funding level, pensions 141 Hardest Hit Fund Programs (HHF) 243 Initial Public Offering (IPO) 48, 60, 61, 75,
fundraising 226 Hayek, Friedrich 23
funds hedge funds 56, 61, 65, 75, 188 183
hedging 52, 63 insolvency by overtrading 38
investment 47 high gearing 40–41 installment credit 204
managed 168–9 high net worth individual (HNWI) 153 instant access savings 86, 166
futures 52, 54, 163 High-Frequency Traders (HFT) 64, 65 insurance
highway-related excise tax 236
G Home Affordable programs 243 against loss 46, 47
home equity 180–81 costs 31, 157
Garfield, James 86 home equity loan 180 insurance companies 70
gearing ratio 27, 40–41 Hong Kong Stock Exchange (SEHK) 55 life 172
General obligation bonds 239 household expenditure 154 property 170
generally accepted accounting principles housing market 243 risk and regulation 78–9
hyperinflation 97, 142, 143, 144–5 interbank lending rate 57, 121
(GAAP) 234 Intercontinental Exchange 232, 233
Germany, hyperinflation 144–5 I interest
gilts 50 and compound interest 208–9
Glass-Steagall Act 240 illiquidity 54, 60 on credit cards 218–19, 244
global data analysis 63 imports 115 from managed funds 168
global financial crisis 35, 75, 82, 92, 128, income on government debt 108, 110
as income 154, 159
215, 236 from managed funds 168–9 on investments 174, 186
global payment networks 204 from pensions 202–3 on loans 43, 210–11
goals, setting financial 150 from savings 150, 166–7 interest cover ratio 41
Gold Standard 18, 95 from share dividends 164–5 interest rates 120–23
Google 47 generating 158–9 central banks and 98, 100–103, 113,
government bonds 50, 102–3, 108, 238 investments for 162–73, 174
government repurchase agreements 87 national 114–15 120–21, 124, 240–41
government securities 238, 239 personal 150 commercial banks 29, 72–3
government-backed (fiat) currency 87 rental income from property 170–71 and debt 206, 207
government-insured loans 242 and wealth 154–7, 160, 161 and exchange rates 138, 139
governments income drawdown 197, 202, 203 fluctuating 122, 167
income tax 106, 126, 236, 237 and government borrowing 108–9, 114
borrowing 108–9 independence, financial 150–51 impact of changing 122–3
financial failure 142–7 index arbitrage 169 and inflation 121
government debt market 238–9 index funds 169, 185 mortgages 72, 177, 214–15
loss of trust 142–3 indirect taxes 106, 107, 133, 135 profitable 72
and money 98–9 industrial organization 13 and quantitative easing 124, 125
mortgage assistance programs 243 industries, subsidised 128 raising/cutting 119, 122–3, 135
providing for the future 130–31 inflation 13, 18, 102, 132–5 and risk of default 146
raising money 105 and debt 110, 111 spread 102
spending 96, 97, 115, 128–9, 135, 237, 239 as economic indicator 116 interest risk 193
see also public finance and exchange rate 138, 139 interest-only mortgages 213
Graham, Benjamin 191 government targets 120 interim reports 62
grants 37 hyperinflation 97, 142, 143, 144–5 internal debts 111
gray economy 126, 127 inflation risk 193 international agreements 107
Great Depression (1929–41) 94–5, 240 inflation targeting 100, 119 International Monetary Fund (IMF) 146, 147
Greece, economic crisis 71, 127, 146, 147 and interest rates 121, 122 International Securities Exchange (ISE) 233
Gresham, Sir Thomas/Gresham’s Law 19 and pensions 200 Internet 220
Gross Domestic Product (GDP) 93, 94, 116, and quantitative easing 125 investing cash flow 39
rate of 100 investment
138, 139 bonds 50–51
Gross National Income (GNI) 115 in business 36, 161
growth 116 company funding 42–3
guarantees 75 day trading 68–9
guarantors 213

INDEX

derivatives 52–3 lender of last resort 100 marginal tax rate 126
dollar cost averaging 190–91 leverage 59, 206 market capitalization 188
earning income from savings 166–7 liabilities market changes, predicting 62–3
financial instruments 46–7 market conditions 190, 191
fluctuating values 185 balance sheets 44–5, 141 market data 69
forex 58–9 bank 88, 89 market equilibrium 20–21
from income 191 personal 152–3 market index 169
goals 192 Libor 57, 67 market makers 61
government 97, 114 life assurance 172–3 market power 134
income-generating 151, 162–73 life insurance 172 market research groups 159
investment companies 80–81 life settlement 172 market value 50, 51, 176, 181
managed funds 168–9, 184–5 lifecycle (“debt phase”) 43 Marx, Karl 22
managing 161, 186–203 lifestyle 156, 192 Mazacoin 221
money market 56–7 lifestyling 163 Medicare 236, 245
and pensions 198–201 liquid assets 152 mercantilism 20, 21
predicting the stock market 62–3 liquid shares 68–9, 76 mergers and acquisitions 75
in property 176–9 liquidity 38, 61, 76, 189 microeconomics 13
rental property 170–71 liquidity trap 95 miners 220, 222, 223, 224
returns 189 and net worth 153 minimum monthly deposit accounts 166
risk tolerance 192–3 listed (shares) 48, 168 minimum repayments 218
shares 48–9, 54, 60–61, 164–5, 182–3 living standards 98, 117, 150, 151, 198 money
and state pensions 140–41 LLCs 235
tax breaks on 246 loan-to-value (LTV) rate 180, 205, 213 artifacts of 16–19
taxes and 246–7 loans barter, IOUs and 14–15
and wealth 154, 155, 157, 159, 161 bank 88, 89 characteristics of 16
wealth-building 174–85 brokers 210 in circulation 88–9, 123
investment assets 152 corporate 41, 47 creation of new 124
investment banks 71, 74–5 cost of 122, 123 in the digital age 220–29
investment companies 80–81 credit unions 216, 217 economic theories of 22–3
investment forums 67 and debt 155, 204, 210–11 economics of 18–19
investment funds 80 government 47 evolution of 12–23
investor types 192–3 government-insured 242 hoarding 95
“invisible hand” 20–21 interest on 72, 73 inflation and velocity of 134
IOUs 14–15, 16 loan agreements 211 printing 96, 97, 104, 105, 143
IRAs (Individual Retirement Accounts) 245 money market and 56–7 purchasing power 132
IRS (Internal Revenue Service) 235, 236, 239 and property value and equity 181 value of 15, 16, 17
Islamic mortgages 213 repayments 36, 37, 210 money market 56–7
secured 121 money market deposits 167
J, K types of 204 money market funds 57
unsecured 121 money supply 13, 86–95
Japan Stock Exchange (JPX) 55 see also mortgages banking reserves 90–91
jewelry, investing in 155 London Stock Exchange (LSE) 55, 61, 65, 182 central banks and 98, 100, 102–3, 241
joint-stock companies 19 Long-Term Capital Management (LTCM) 65 government and 98–9
junk bonds 51 long-term liabilities 152 increasing money circulation 88–9
Keynes, John Maynard 22–3 low gearing 40–41 recession and the money supply 92–3
lump sum investment 190, 191 recession to depression 94–5
L MONIAC 114, 115
M mortgage banks 72–3
Laffer, Arthur/Laffer curve 127 mortgages 155, 157, 198, 199, 205, 212–15
laissez-faire 20, 21 macroeconomics 13 buy-to-rent 176
landlords 170–71 Madoff, Bernie 35 buy-to-sell 176
late fees 211 maintenance, property 170, 171, 177 choosing 177
latent demand 134 managed funds 174, 183, 184–5 eligibility 242
leasing, assets 33 and home equity 180–81
Lehman Brothers 35, 71 investing in 163, 168–9 interest rates 122
margin call 59 Islamic 213
margin trading 69 mortgage assistance 243

252 253HOW MONEY WORKS
Index

mortgage rates 214–15 operating cash flow 39 positive net worth 153
subprime 92, 215 operating expenses (property) 176 preference shares 163, 165
trends 243 optimal portfolios 187, 194–5 premiums, insurance 78, 79
types of 212–13, 242 options 52, 54, 163 prices
United States 242–3 ordinary shares 163
MSCI EAFE 169 outgoings 154–5, 156, 157 hyperinflation 144–5
multisector funds 168 over 24-hour-maturity money market funds inflation 116, 132–5
multiplier effect 91 and market equilibrium 20–21
municipal bonds (Munis) 239, 246 87 price data 63
mutual funds 246 overdrafts 37, 73 price stability 100, 120
overheads 36 property 135
N overleverage 41 primary markets 60–61, 232
prime rate 240–41
narrow money 86 P private activity bonds 246
Nasdaq (National Association of Securities private investment 131
partnerships 235 private pensions 196–7, 198
Dealers Automated Quotation System) passive income 158, 159, 160 privatization 131
61, 232–3 passively managed funds 168 profit
Nasdaq Composite 233 pawnbrokers 83 downturn in 34
National Association of State Budget payday loans 210 margins 72
Officers (NASHO) 237 payroll tax 37, 236 reported 34
national debt 238, 239 peer-to-peer lending 82, 166, 167, 220, 221, and share dividends 165
national income 115 steady increase in 35
National Insurance (NI) 106, 140 228–9 profit and loss accounts 34, 35
National Stock Exchange (NSE) 233 pension contributions 199 profiting 55
natural resources 32–3, 136 pensions 196–203 property
negative cash flow 39 buying and selling for profit 178
negative equity 181, 213, 243 consolidating 203 commercial vs residential 178
negative interest 193 converting into income 202–3 home equity 180–81
negative interest rate policy (NIRP) 123 pension funds 61, 201 investment in 161, 176–9
negative net worth 153 saving and investing for 198–201 mortgages 212–15
net income 26, 28–9, 106 and share prices 183 prices 135
net worth 150, 152–3 see also private pensions; state pensions property cycle 178–9
New York Stock Exchange (NYSE) 49, 55, personal finance 148–229 property market 80, 176, 178
60, 61, 64, 232–3 debt 204–19 property tax 246–7
nominal rate 121 income-generating investments 162–73 rental income 155, 163, 170–71, 186
nominal values 133 managing investments 186–95 and wealth-building 175
nonbank financial institutions 70, 82–3, 242 money in the digital age 220–29 protectionism 21
not-for-profit organizations 205, 216, 217 pensions and retirement 196–203 provision, making 34
notice savings accounts 72, 87, 166 United States 242–7 public companies 60, 183
NYSE Amex 233 wealth-building investments 174–85 public debt 110–11
NYSE MET 233 worth, wealthy and income 150–61 public finance
personal loans 204 attempting control 114–41
O Philadelphia Stock Exchange (PHLX) 233 managing state finance 96–113
Phillips, Bill 114 money supply 86–95
Office of the Comptroller of the Currency Pigou, Arthur/Pigouvian tax 126 United States and Canada 236–41
(OCC) 234 pledges, online 227 why governments fail financially 142–7
portfolios public services 104–5
Office of Consumer Affairs (OCA) 234 asset allocation and diversification 188–9 public trust, loss of 142–3, 144
Office of Management and Budget (OMB) brokers’ fees for managing 76
diversified 80 Q
239 investment 47, 79, 162
Office of the Superintendent of Financial optimal 187, 194–5 quantitative easing (QE) 98, 114, 124–5, 241
portfolio income 159 quoted shares 48, 182
Institutions (OSFI) 234 portfolio weighting 187, 189, 195
offset mortgages 213 rebalancing 175, 195
online brokers 76 positive cash flow 38
online market places 159, 182 positive equity 180
open market operations 98, 100, 103

INDEX

R government 96, 115 government 238, 239
and net income 28 Securities and Exchange Commission (SEC)
raw materials, cost of 132, 133 and taxation 106, 236
real profit 28 Revenue bonds 239 233
real rate 121 reverse annuity mortgages 212 seed capital 43
real values 133 revolving credit 204, 219 self-employment tax 236
real-estate cycle, 18-year 179 Ricardo, David 21 Shanghai Stock Exchange (SSE) 55
real-time trading 77 Riksbank (Sweden) 103 shareholders
recession 146, 215 Ripple 221
risk payments to 36, 48, 49
and depression 94–5 balancing with rewards 187, 189, 194–5 say in running of companies 182
and money supply 92–3 control 46 shares
regulation gearing ratio and 40–41 arbitrage 64–5
banks 82, 83, 92, 234, 240 insurance 78–9 as assets 155
credit cards 244 investments 47, 162–3, 186 brokerage 76–7
insurance industry 79 and managed funds 168, 169 buying 54
mortgage products 215 peer-to-peer lending 229 day trading 68–9
peer-to-peer lending 221 risk tolerance 187, 192–3 dividends from 164–5
stock exchange 233 rogue traders 55, 66–7 earnings per share 28
remortgage 213 Roosevelt, Franklin D. 95 as financial instruments 46, 48–9
rental income 154, 158, 159, 163, 170–71, Roth IRAs 245 and gearing ratio 40
Royal Mint 19 guarantees 75
174, 186 royalty payments 159 high risk investment 163
repairs, property 170, 171 RSCoin 221 how to buy 182–3
repayment mortgages 212 Russian financial crisis 65 investment in 182–3, 186
representative currency 87 issuing 42
reserve currency 139 S liquid 68–9, 76
reserve rates 100–103 manipulating prices 66–7
reserve ratio 90, 98, 102 safeguarding 228 predicting market changes 62–3
reserves, banking 90–91, 124–5 salaries and wages 13, 31, 36, 117, 154, 156, 158 primary and secondary markets 60–61
residential property 178 repurchases 36
retirement 156, 157, 196–203 cost of 132, 133 stock exchange 54–5
sales predictions 38 unsold 61
age of 161, 196 sales revenue 36 and wealth-building 175
managing state pensions 140–41 sales tax 37, 237 why share prices matter 183
planning for financial independence Sargent, Thomas 145 sharesave plans 182
savings Shenzhen Stock Exchange (SZSE) 55
150 – 51 shopping 157
United States 245 credit unions 216, 217 short selling 66
see also pensions; state pensions earning income from 162, 163, 166–7 short-term liabilities 152
returns from income 150, 154, 155 Simmel, Georg 17
on assets 88, 113, 188, 189, 198 interest rates 121, 123 single asset funds 168
credit unions 217 and investing for a pension 198–201 SIPPs (Self-Invested Personal Pension) 198
crowdfunding 227 regular savings plans 185 slump 34
government 130, 131 savings accounts 72, 73, 159, 162–3, 246 Smith, Adam 14, 20–21
on investment 40, 47, 51, 79, 81, 130, 131, savings bonds 50, 51, 238 smoothing earnings 26, 34–5
savings rates 72 social housing 131
141, 154, 161, 162, 174, 186, 198 tax on 246 Social Security 245
managed funds 168, 169, 185 and wealth 154, 155, 156, 157, 160, 161 taxes 236
optimal portfolios 194–5 scalping 69 soft drinks, tax on 126–7
peer-to-peer lending 228 scandals specialty lenders 83
pensions 201, 203 accounting 35 speculation 52, 53
on property 176, 177, 178 Libor 67 spending
savings and deposit accounts 159, 162, 163 scientific research 128, 131 government 96, 97, 115, 128–9, 135, 237, 239
snowball effect 208 secondary markets 60, 61, 68, 102, 232 increasing/cutting 119
standard deviation of 191 secured loans 121, 204, 210 personal 156–7
vs risk 166, 187, 192–3, 194 securities 51, 60, 76, 80, 101 vs cuts 128
see also yield and wealth 156, 160
revenue
analysis 62

254 255HOW BUSINESS WORKS
Index

spread (forex) 59 and pensions 197, 200, 202 utilities, government investment in 130
Standard & Poor’s 500 169, 233 and state pensions 140 utility costs 31, 36
standard deviation 195 tax evasion and avoidance 107, 126, 127
standard of living 98, 117, 150, 151, 198 tax havens 107 V
standard variable rate (SVR) mortgages 214 tax rate 107
start-ups 43 tax refunds 37 variable-rate mortgages 214
state finance, managing 96–113 tax relief 126 variance 195
tax returns 107 VAT 37, 106, 107
accountability 112–13 unintended effects of 127 vault cash 90
budget constraint 104–5 United States and Canada 236–7 velocity of money 134
the central bank 100–103 technical analysis 62, 63 venture capital 43
government borrowing 108–9 term deposits 163 viatical settlement 172
governments and money 98–9 term insurance 172 volatility 34, 52, 53, 80, 169, 190, 191
how tax works 106–7 Tesco 29
public debt 110–11 third markets 61 W
state pensions 198, 201 “tickers” 54
managing 140–41 tobacco, tax on 106, 126, 236 wages see salaries and wages
and retirement 196–7 Toronto Stock Exchange (TSE) Wall Street Crash (1929) 94
state taxes 236–7, 239, 247 wallets, digital 223, 224
statements, company 44–5 55, 233 Warren, Elizabeth 141
stock exchanges 48–9, 54–5 tracker mortgages 215 wartime, government debt in 111
New York Stock Exchange 232–3 trade, and money 12, 14–15 wealth 150–61
stock liquidity 67 traders 62
stock market trading volumes 63 calculating and analyzing net worth 152–3
crashes 201 transatlantic trades 64–5 generating 160–61
financial markets 54–5 transparency 113 and income 154–9
manipulating 66–7 transport and managed funds 184–5
predicting 62–3 and property 176–81
shares 48–9, 182, 183 cost of 132 and shares 182–3
stockbrokers 182, 183 government investment in 130 wealth-building investments 174–85
stocks 48 traveler’s checks 86 worth, wealth and income 150–51
see also shares Treasury Bills 57, 238 wear and tear 32, 33
stop loss 59 Treasury Bonds 238 weighting 195
strategic asset allocation 188 Treasury Inflation-Protected Securities Welch, Jack 35
subprime mortgages 92, 215 welfare spending 128
subsidies, government 128 (TIPS) 239 wills 161
superannuation 163, 174 Treasury Notes 238 Wilshire 5000 169
suppliers, payment of 37 trust, public 142–3, 144 Wilson, Woodrow 240
supply and demand 13, 134 windfalls 37
surplus 110 U WorldCom 35
survivor benefits 245 worldwide markets 71
underwriting 75 worth, net 150, 152–3
T unearned income 159
unemployment 13, 93, 117 Y
tax-free deposits 167
taxation 96, 106–7 in a depression 94 yield
and exchange rate 138, 139 bonds 50, 51
and behavior 106, 126 and inflation 118–19 dividend 164
and cash flow 37 and interest rates 122, 123 rental property 170–71
corporate 235 unit trusts 184 see also returns
and government funds/debt 104–5, 108, United States
company finance 232–5
109, 110, 114, 128 personal finance 242–7
increasing/cutting 118, 133, 135 public finance 236–41
and investments 246–7 units (managed funds) 169, 184, 185
level of 126–7 unlisted funds 168
and money supply 98 unsecured loans 121, 204
optimum level of 127 US Bureau of Labor Statistics 117
US dollar 19

ACKNOWLEDGMENTS

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financial-corporates-cash-pile-increases-to- org/series/MKTGNIJPA646NWDB; p.117: savings/discount-pensions; p.201: www.
168--PR_349330; p.29: www.apple.com/uk/ www.bls.gov/k12/history_timeline.htm; un.org/en/development/desa/population/
pr/library/2016/01/26Apple-Reports-Record- p.123: www.tradingeconomics.com/ publications/pdf/ageing/WPA2015_Report.
First-Quarter-Results.html; p.33: www.theaa. argentina/inflation-cpi; p.125: www.aei.org/ pdf; p.203: www.irs.gov/retirement-plans/
com/motoring_advice/car-buyers-guide/ publication/since-2009-feds-qe-purchases- retirement-plans-faqs-regarding-iras-
cbg_depreciation.html; p.39: www. transferred-almost-half-trillion-dollars- distributions-withdrawals; p.205: www.
modestmoney.com/cash-flow-problems-small- treasury-isnt-gigantic-wealth-transfer/; p.127: nerdwallet.com/blog/credit-card-data/
business-startups-tackle/9820; p.41: www. www.economist.com/news/finance-and- average-credit-card-debt-household/; p.207:
tutor2u.net/business/reference/gearing-ratio; economics/21623742-getting-greeks-pay- libertystreeteconomics.newyorkfed.
p.47: www.cnbc.com/2015/07/17/googles- more-tax-not-just-hard-risky-treasures; p.128: org/2016/08/just-released-recent-
one-day-rally-is-the-biggest-in-history.html; federal-budget.insidegov. developments-in-consumer-credit-card-
p.49: en.wikipedia.org/wiki/New_York_ com/l/120/2017-Estimate; p.135: www. borrowing.html; p.210: www.theguardian.
Stock_Exchange; p.51: https://www.ft.com/ federalreserve.gov/faqs/economy_14400.htm; com/business/2014/dec/16/wonga-cuts-cost-
content/ed4dbdb2-23c2-11e5-9c4e- p.139: www.dailyfx.com/forex/education/ borrowing-interest-rate; p.213: eyeonhousing.
a775d2b173ca; p.53: en.wikipedia.org/ trading_tips/daily_trading_lesson/2014; org/2013/01/latest-study-shows-average-
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p.59: www.wsj.com/articles/pound-drops-to- of Financial Folly – Preface Reinhart, Carmen p.215: news.bbc.co.uk/1/hi/business/7073131.
31-year-low-against-dollar-on-brexit- and Rogoff, Kenneth University of Maryland, stm; p.217: www.woccu.org/; p.220:
concerns-1475566159; p.60: www.nyxdata. College Park, Department of Economics, thefinancialbrand.com/45284/banking-
com/nysedata/asp/factbook/viewer_edition. Harvard University 2009; p.145: www. mobile-payments-bitcoin-research/; p.223:
asp?mode=table&key=3003&category=3; globalfinancialdata.com/gfdblog/?p=2382; en.wikipedia.org/wiki/List_of_
p.65: www.dbresearch.com/PROD/DBR_ p.147: en.wikipedia.org/wiki/European_debt_ cryptocurrencies; p.227: www.kickstarter.
INTERNET_EN-PROD/ crisis; p.151: www.forbes.com/sites/ com/about; p.229: www.statista.com/
jamiehopkins/2014/08/28/not-enough-people- statistics/325902/global-p2p-lending/

100 101GOVERNMENT FINANCE AND PUBLIC MONEY
Managing state finance

RtWchoeeihgonsehterhn,artilthvghbeeeharndrekaesemmtrevaoenndienyftoeisrrest Central bank Reserve rate
too low
rate rises. The central bank creates and supplies reserve
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 central bank reserves lowering the interest rate, bringing the base of central bank reserves
in the system. As more bringing it back in line with rate up, back in line in the system. As a
money is available, the the target interest rate. with its target. result, the demand for
cost of borrowing − the money and the cost of
interest rate − decreases. borrowing it 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.
as when interest rates are lower, ❯❯The spread The difference
saving is less appealing and between the cheapest and the
borrowing more, 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. Investors deposit the
money from the sales, which increases the amount of reserve money in
the open market. Commercial banks then respond by lowering interest rates.

Central bank Investors in Commercial banks General public Money supply
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 means bonds in the open market to affect Swedish Riksbank,
that it is able to influence how the short-term rates of interest. was established
commercial banks lend. It can, for
example, give commercial banks Credit access
incentives to encourage them
to offer very low interest rates to The central bank can restrict access
important sectors of the economy. to credit for commercial banks, 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 then 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
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 by governments.

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 its 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

Defence

HOW GOVERNMENTS RAISE MONEY

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

Ho using and th e ❯❯Taxes Governments
t environmen can levy taxes on
Healthcare what the population
Education earns and owns, and
on foreign trade.
Taxes are safe, but
unpopular.

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 the revenue
needed to pay for public spending. Governments may tax the public
directly (such as with 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 UK are shown below.
taxes. These can be divided into
“direct” taxes, which are paid from DIRECT TAXES National insurance 12.5%
earnings, either by people or by
institutions, and “indirect” taxes, £ This is a tax on earnings levied on
which are paid for out of consumer employees and employers to pay
spending. Taxes can be levied as a for social services.
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, taxation rates, and laws
about who or what pays for which
taxes, vary significantly from
country to country.

TAXES AND Income tax 20% Net income
BEHAVIOUR
Income tax is paid Once taxes on earnings
Some taxes are designed to reduce directly out of an have been paid out, the
the amount of revenue that goods individual’s earnings. amount remaining is
earn. Because a newly-levied or called “net” income.
increased tax on a product raises its £
price, that item becomes less
attractive to buy. Where a product, NET INCOME
such as cigarettes, is harmful, higher
taxes can be a way to reduce public
consumption. In cases in which the
behaviour of consumers does not
alter much in response to higher
pricing, however, the extra tax is
likely to raise much more money.
This can make such taxes appealing
for governments seeking revenues.

106 107GOVERNMENT FINANCE AND PUBLIC MONEY
Managing state finance

US$21 trillion NEED TO KNOW

thought to be hidden ❯❯Tax return A document used to
in tax havens abroad record individual and company
income and calculate the tax due.
INDIRECT TAXES
❯❯Tax rate The amount at which an
Other variables £ individual or a company is taxed;
rates vary according to a person’s
Taxes can be applied to anything. income or a company’s returns.
Germany has a tax on dogs and
the UK once taxed windows. ❯❯International agreements
Contracts that act as a restraint
Excise duty on taxation, such as in stopping
import duties from being levied.
Many goods, particularly
imported ones, attract an TAX EVASION AND
additional tax, known AVOIDANCE
as an excise duty.
Because tax systems vary widely
VAT 20% from country to country, it is
possible for companies and some
Value Added Tax rich individuals to exploit the
adds an extra 20 differences in international tax
per cent on top rates to reduce the total amount
of the cost of a of tax they pay. This is termed tax
product or service. “evasion” when done illegally, and
tax “avoidance” when performed
£ legally, although in practice the
boundaries 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

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

Managing the debt

Governments keep a careful eye on
their overall level of debt, since high
levels of debt mean greater interest
repayments. Very elevated levels of
debt may even become impossible to
repay if tax revenue proves insufficient
to keep pace with elevated interest
rates. Furthermore, a heavily indebted
country that investors see as a risky
prospect may find it difficult to borrow
enough to cover day-to-day spending.

Borrowing

Governments typically borrow
money by issuing bonds to
individuals and financial
institutions in exchange for a
loan. The government will
then pay a fixed rate of
interest over a period of time
to the investor, paying the
bond back in full when
it reaches maturity.

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

a 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 of a Any debt that a government takes on
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 sum of money owed by a country’s government,
including its 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 all its previous governments) is known as the a year, it has a “surplus”, which can be used to pay off
public or national debt. This is generally calculated as the debt. Inflation can also help reduce a debt burden.
the total debt minus the government’s liquid assets. A state that becomes unable to pay its debt is said to
Interest is due on this debt, and it can be substantial. “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 that 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
is able to 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.
in the 17th century, were a 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
default. weight of
internal debt
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 to dominate the debate during national elections.
Before the 2008 crash, monetary policy − changing
Democratic countries typically insist that governments interest rates and influencing the money supply − had
report annually to their legislative bodies about their been increasingly left to central banks. However, since
taxation and spending plans − their fiscal policy. The the crash, the policy, and the banking system’s role in
annual budget has become the central instrument of it, have been subject to more rigorous examination.
governments’ economic policy, and its contents tend

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 Typically an annual budget
the 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
economic projections. To this end, a policies should all be clearly outlined. ❯❯Audited financial statements
central bank should 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
Financial institutions
bank decides on a set committee to give further and the specialist
rate of interest. explanation when required. press pay especially
close attention to
Minutes of policy the central bank’s
meeting published decisions.

Reports of the central bank’s
decision-making process

are made 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 behaviour, and attempting to balance
competing demands for resources, is therefore a continual challenge.

Economic machine INCOME Tax
Total earnings
This design is based on a real machine, in 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 a real economy,
the indicators these readings represent CONSUMPTION
are collected and produced by the EXPENDITURE
country’s national statistical bureau, Household income
generally using survey data to assess minus household savings.
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 US$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 economy’s
National income accounting total earnings must match its
is a method that a national total spending. This basic idea
government uses to measure the allows economists to build
level of a country’s economic and study models such as
activity in a given time period. the MONIAC machine.

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

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

116 117GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

How it works the employment and labour 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 analyse data

Unemployment Wages

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

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 in the economy, 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 and unemployment rises.
economic machine
$
Governments have a number of different controls they
can adjust to help the smooth running of the economy. Increasing tax
The biggest are taxes, spending decisions, and interest
rates. Each of these controls affects the economy in The government can try to slow
many different ways, and governments have to consider down the economy by raising
a range of potential outcomes when taking action. taxes, a measure taken when
inflation is a risk. An increase in
“Inflation is the one taxes reduces spending. When
form of taxation spending falls, suppliers are less
that can be imposed likely to put up their prices, since
without legislation” they risk losing a market, and
inflation therefore slows. Cutting
Milton Friedman, US economist 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.
Economic policy-making has been compared to trying More recently, economists have concluded that
to operate a finely balanced machine. By adjusting economies run best by themselves, with institutions
various policy “dials”, the government aims for the such as central banks controlling monetary 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 down Raising interest rates
and there is a risk of a rising rate of
unemployment, the government The government, by setting its
can try to stimulate the economy inflation targets, directs the central
through increasing spending. By bank to change the base rate, which
encouraging public spending, in turn influences interest rates.
the state increases the likelihood When rates rise, borrowing costs
of firms employing more people becomes more expensive, people
to meet the extra demand. Cutting spend less money, and businesses
spending has the opposite effect. may feel they need to reduce their
prices, so lowering inflation. Cutting
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). The central bank 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

The government The 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 passed on to the central bank, on money they borrow from
the rate of employment. One such who then set the base rate – the the central bank, making it
aim is to achieve price stability, as interest rate that the central bank more expensive for them to
this makes for stable economic charges commercial banks to borrow. Lowering the base rate
growth. Prices are kept steady when borrow from it. The central bank means that commercial banks
inflation occurs at a limited rate, and does this in order to encourage pay less interest on the reserves
so the government sets an inflation commercial banks to adjust their they borrow from the central
target, beyond which prices should rates in line with the base rate. bank, which makes their
not rise or fall. This is announced Commercial bank rates determine
annually, expressed as a percentage the ease with which customers and borrowing cheaper.
of the Consumer Price Index (CPI). businesses can borrow, so it affects
The CPI is measured as the cost of a investment, spending, employment
selection of representative goods rates, and wage levels in the wider
and services bought by a household, economy. These in turn influence
including food, transportation, prices charged for products, which
clothing, and entertainment. affects inflation (see pp.122–123).

120 121GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

HOW INFLATION AFFECTS INTEREST RATES NEED TO KNOW

Interest rates and inflation are closely A loan is a product and an interest rate ❯❯Nominal rate An advertised
linked, and a change in one influences the price paid for it, so if the value of interest rate, which does not factor
the other. 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 on into account and is calculated by
that money devalues, and so more spending, causing the money supply subtracting the inflation rate from
of it is required to obtain products. 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 collateral. This
if the cost for them of borrowing 26% PERSONAL makes them
from the central bank increases LOAN riskier to lenders,
(as the base rate goes up), or the 8% who may charge
inter-bank lending rate increases, £ higher interest
they need to reflect this in the rates as a result.
interest rates that they charge
their customers for borrowing. 5% Secured loans Secured loans
Commercial banks set interest 2% are backed by
rates according to their own needs MORTGAGE collateral, such
so some banks may choose not 1% WITH 10% as property.
to pass lower interest rates on to £ DEPOSIT Mortgages
customers taking out loans, while are secured by
other banks may offer a higher MORTGAGE houses. Banks
interest rate on savings in order WITH 50% do not have to
to attract new customers’ money. £ DEPOSIT pass on base rate
changes unless
the borrower
has a tracker
mortgage
(see pp.214–215).

INTER-BANK 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 on
the affordability of obtaining or repaying an existing
If interest rates fluctuated all the time, the economy loan, such as a mortgage. By contrast, a drop in
would become volatile. This is why the government interest rates is intended to stimulate spending, since
and central bank work together to keep inflation and consumers can take out loans more cheaply, while
interest stable. Every time the interest rate is changed, savers will tend to spend or invest deposits that are
it sends a signal to consumers to either spend or save – attracting little interest. Interest repayments will also
and may also increase or decrease confidence in the drop for those with mortgages tracking the base rate,
state of the economy. An increase in interest rates leaving more cash for spending. While encouraging
encourages saving, since higher interest will be paid spending through very low interest rates might boost
on money in savings accounts, and investments can the economy, it can ultimately impact negatively on
grow. Meanwhile, borrowing becomes less attractive long-term savings plans, such as pensions.
as interest repayments increase, and banks are 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.

% HOW THIS EFFECTS THE ECONOMY

Economy The central bank Investment Demand falls
expected to grow raises the base decreases due to overall in the
interest rate costly loans and
low confidence economy
% Inflation falls
Household
Commercial banks consumption 2
raise interest rates; decreases, with
loans become more less spending
expensive, but savers and more saving

are rewarded Companies may
0 TIME (YEARS) find they are less
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 investment, and discourage savers Argentina’s rate
has experimented with cutting base from hoarding cash, commercial of inflation in
interest rates to a negative figure, for banks usually tend to be reluctant April 2016, the
instance, − 0.01 per cent. If this rate to pass negative interest charges world’s highest
were passed on by commercial banks, on to customers, and particularly
it would mean that depositors must small businesses, as depositors may
pay a percentage of their deposit to be driven to withdraw their savings in
the bank. But while a central bank cash to avoid fees. Large depositors,
might impose a negative interest however, may pay negative rates for
rate to encourage spending and security 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, while 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 INTEREST RATES
expected to The central bank increases due to rises overall
reduces the base cheap loans and in the economy
contract high confidence
interest rate Inflation
Household rises
% consumption CREDIT
increases with 2
Commercial banks more spending
reduce interest rates; and less saving
loans are cheaper, but
saving becomes less Companies may
become more
rewarding profitable as loans
0 TIME (YEARS) and investors are
easier to secure

1

Quantitative easing

Quantitative easing is a 21st-century strategy aimed at boosting the
economy. It uses the 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, balanced way. the liquidity of money in the economy, which will in
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 and more attractive. This, in turn, should encourage
can encourage financial institutions to lend more to businesses to invest and consumers to spend more,
businesses and individuals, which encourages them thus boosting the economy.
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 not being felt across the whole economy.
of new money – usually taking 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.

$$$

The central bank The central bank COMMERCIAL BANK
creates new money uses 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

POTENTIAL DANGERS OF QE CASE STUDY

QE is a relatively new strategy so its effects are hard to measure. It is therefore UK
still not known whether it can stimulate the economy without excessive risk.
The UK began a QE programme in
The economy may Inflation may occur Banks don’t always early 2009, after interest rates were
not fail to respond as due to high money pass on the money cut to almost zero. Most of the new
expected even to very supply – although it is to businesses in need, money has been used to purchase
large amounts of new unlikely to lead to but hoard it or invest government debt. The effects of
money being created. hyperinflation. it elsewhere. QE depend on sellers passing on
the money that they receive from
selling assets, and banks investing
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.

US$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.100- Individuals and businesses Increased spending
101), leading individuals and use loans to buy goods and business investment
businesses to borrow more. and services and to invest boosts economic activity.

in 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 100ml are taxed at 8p per 9.9g
Governments can impose taxes on a person’s earnings, can/carton – or 24p per litre.
their buildings and homes, savings and investments,
pensions, inherited property, or on what they spend. Carib No Sug Fiasco Peppy Bro
Most governments rely heavily on income taxes, Ginger Bull Nite 10.3g
usually with different proportionate levels for different 11g 10.6g 10.6g 10.6g
levels of earnings. This makes the tax system fairer; Ale
however, introducing more complexity also increases 15.2g
the chances of tax avoidance. Some taxes are also
levied in order to change behaviour. By taxing Drinks with 5-8g of sugar per
something viewed as negative or unhealthy, such 100ml are taxed at 6p per can/
as tobacco or alcohol, the government can help to carton – or 18p per litre.
persuade people to consume less of those things.
7.5g Dr Orango Lifta 5.1g Schmoozer
Pigouvian taxes in action Cafteen Jones 6.5g 6.6g
6.3g
Standard economic theory says that if consuming goods or
services causes harm, a tax should be applied to them until
the value of the tax matches the cost of the harm done –
for example, a tax on sugar should match the cost to public
health services of obesity. This is a “Pigouvian tax”, named
after Arthur Pigou, the economist who proposed the idea.

NEED TO KNOW Milk- and fruit-based drinks, Sea
teas, and coffees are not taxed, Mist
❯❯Effective tax rate Many tax systems allow different 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 for
undertaking a small amount of extra activity – for
example the extra tax paid in earning £1 more. Decisions
made “at the margin” influence the behaviour of
individuals and businesses, such as whether it is worth
working longer hours.

❯❯Grey 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
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THE LAFFER CURVE

The Laffer curve, named after US economist Arthur Laffer,

illustrates the concept 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, they

£££ ❯❯Drinks taxed at the higher rate will eventually decline. Controversy surrounds the idea
are actually taxed less per gram because it is very hard to know where this optimum point
of sugar than those at the lower might lie and also because it would seem to legitimize
rate – so consumers may switch non-payment of taxes by high net-worth individuals, and
to more sugary drinks. tax avoidance by ordinary people who start to participate
in the “grey economy”.
❯❯Consumers may turn to untaxed

sugary drinks such as milkshakes GOVERNMENT REVENUE

and smoothies.

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

❯❯The 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 per cent tax on TAX RATE
soft drinks has raised more than
US$2 billion since 2014. While 24%
sales initially dropped they
have started to rise again.

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

Government
spending

Governments today spend a large part of what an economy
produces, using money from taxes to prioritize their political
commitments and potentially boost their country’s economy.

How it works Typical government Health 22%
spending IpnatTeyrrmaensestnptosr5t %3%
Modern governments usually
pay for a range of services that How a government spends money
might typically include education, depends on its political priorities,
healthcare, pensions, and welfare the size of the government relative
payments. The electorate may also to the economy, and its level of debt.
expect them to invest in roads, For instance, Scandinavian countries
airports, water, electricity and gas famously prioritize high welfare
supply, and other infrastructure. spending. Government spending
can also boost the economy. By
However, governments cannot raising spending on infrastructure,
simply spend whatever they want. governments can help to sustain
Healthy tax revenues depend on a economic activity. Funding scientific
thriving national economy. Most research aids product invention,
governments attempt to prioritize feeding into economic growth, while
their spending depending on their spending on education can provide
political commitments, setting an the training to make a workforce
annual budget to allocate spending more productive.
from taxes they expect to receive.

SPENDING VS CUTS Defence 6%

Government spending can directly “Never spend
support the economy, your money
such as expenditure on transport before you
and communications. Scientific have it”
research is often funded by
government, and spending on Thomas Jefferson, former US president
education helps to train workers.
Some governments also subsidise
and support key national industries.
However, many governments since
the 2008 financial crash have tried
to cut their spending to reduce
their deficits (see pp.146–147).
These decisions are controversial,
as the long-term effects on the
economy are still unknown.

128 129GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control

Pweelnfsiaroens31a%nd GOVERNMENT SPEND
RELATIVE TO ITS ECONOMY
Education 13% Other 20% COUNTRY
The size of a government’s budget in
relation to its economy, can vary.
Typically, governments spend around 40
per cent of GDP. The graph below shows
some of the variation. In South Korea the
government spends 30 per cent of GDP,
while in Denmark it spends 58 per cent.

USA
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 Sometimes, governments will also invest in building
new housing or sponsor research.
Governments usually take responsibility for providing
the buildings public services use, and for building and Spending on this is government investment, and
maintaing essential national infrastructure such as appears as its “capital” spend in the national budget.
railways, electricity and gas supplies, and roads. 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 Cash from energy bills ❯❯Direct Cash from utility bills

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

❯❯Long-term A growth in ❯❯Long-term More investment ❯❯Longer-term Health and
businesses activity 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, allows the private investors to share
produce a return over its lifetime. governments (just like businesses) in the returns. In some cases this
In some cases this return is paid will often borrow money. This means means full privatization, in which
directly (for instance in passenger adding to their overall debt, and so a government allows a private firm
fares) and sometimes it appears governments concerned with cutting to build and run the investment
indirectly (for instance in the many debts will often look first at ways of outright. When this is not possible
economic benefits of a new road, reducing capital spending. However, or desirable, private investment may
helping businesses to trade and this means missing out on the returns take the form of a deal between
resulting in more tax revenues). of an investment so, in order to lower government and private investors
Governments justify such spending the costs, many governments have to split the costs, risks, and profits of
by showing it will produce returns. began to use private funding. This building and 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
leading to a more stable
society with less homelessness ❯❯Longer-term A 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 comes about when a high demand
a major impact. There are two for goods exceeds firms’ ability or
Inflation is the year-on-year rise main types of inflation: “cost-push” willingness to provide them. Rather
in general prices. This increase is and “demand-pull”. Cost-push than increasing supply to match
usually measured by the cost of a inflation is driven by businesses rising demand, businesses raise
basket of representative household experiencing rising costs, which are their prices instead. This alone
goods. As more money is needed to then passed on to their customers. would not cause demand-pull
buy the same goods and services, A business’s expenses might go inflation, but if there is also an
the value of money decreases, and up for a number of reasons, such oversupply of money in the
day-to-day living becomes more as an increase in production costs economy, then consumers will
expensive. There are various factors or the need to raise the wages of continue to pay elevated prices,
that influence inflation, but changes employees. Demand-pull inflation raising them further.
in the supply and demand of goods

Cost-push inflation $

There are several factors that can cause costs to rise. An increase in the price
of raw materials, for instance, can have a knock-on effect, leading to a rise
in prices throughout the economy. Increased energy and transport 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 necessary materials increases
The availability of an essential commodity,
oil, becomes limited, raising its price
and the cost of transport, 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, US economist

$

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 CAUSES OF COST-PUSH INFLATION
The employees demand
better pay, as it appears Cost-push inflation is driven by a rise in running costs
that prices are rising. The for businesses. This can have a number of causes.
company agrees and their
overall costs increase. ❯❯Costs of raw materials Rises might be due to a scarcity
resulting from a natural disaster, or an artificial limit
NEED TO KNOW 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 ❯❯Labour costs Strikes, low unemployment − meaning
of inflation. that firms need to pay more in order to attract skilled
labour − strong unions, and staff expectation that
❯❯Real values Figures adjusted for inflation and used general prices will rise can all result in firms raising
when looking at economic variables over a period of wages and shifting the extra 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 VAT 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 chasing
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
would 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 less money is customers who have a desire to
velocity of money, the supply of pumping around an economy, then buy a product, rather than those
goods and services may not be 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 firm’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
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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. A rise in spending is caused and firms feel confident about the
inflation by several factors. 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 the money can cause home owners to feel more
supply, and result in 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 ❯❯Rapid growth abroad High export
state can expand the money supply, sales can increase the amount of
resulting in more consumer activity. money flowing into the country,
with a knock-on effect on inflation.

$ $
$
$
$

$
$ Prices rise 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 raises by raising prices, rather
the income to meet a higher price its price. How high a price may rise than output, then
point and are willing to pay more for depends on consumer demand inflation will rise.
a product they perceive as valuable. for the product; if 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: the money is coming into and leaving
current account, which measures goods and the country, and in which economic
services; the capital account, which tracks areas there is a deficit or surplus.
the movement of capital and non-financial
assets; and the financial 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. In reality, as a result of variations
in accounting practices and regular 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 accounts ❯❯Capital transfers, such as money Credit Debit Debit
are, in turn, divided into sub- transfers or assets of migrants +€2bn –€1bn –€1bn
accounts, to chart specific areas
of expenditure. ❯❯Non-produced, non-financial 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 non-financial,

Currency and non-productive 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 €€

Money in Balance of payment Money out
€5bn –€5bn
The sum of the “balance
of payment” should equal
zero, 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 – GDP (gross Weak currency
change from day to day, which is domestic production), inflation,
why exchange rates also fluctuate employment, and interest rates – Several economic factors –
continuously. These currency indicate how well a country’s either by themselves or
fluctuations are determined in economy is performing, and combined – can trigger a fall in
foreign exchange markets around 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 rates of
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 favour 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

$$ US$5.3
trillion
Bank actions Strong currency
the typical
When a country’s Several economic factors can value of foreign
central bank expects signal a booming economy, and exchange trades
the currency’s value to boost demand for the country’s made each day
drop, it tries to shrink currency and increase its value.
the money supply. THE IMPORTANCE OF
HIGH INTEREST RATES % RESERVE CURRENCY
Bank Higher rates attract
foreign investors and Reserve currency is a recognised safe
INCREASING THE increase the value of foreign currency held by a country’s
INTEREST RATE the currency. central bank and financial institutions
Raising the interest rate and used to make trade payments.
attracts investors to buy STABLE INFLATION $ Using the reserve currency avoids the
the country’s currency as Stable or falling need to change payments into local
they will benefit from the inflation can help currency, minimizing the exchange-
higher rate of interest. to boost the value rate risk for both countries. Many
of the local currency. central banks set a reserve ratio –
SELLING FOREIGN the percentage of deposits that the
RESERVES RISING GDP bank must hold. The US dollar is
Selling foreign reserves High production rates the currency most commonly held
and retaining domestic demonstrate demand in reserves worldwide.
currency increases for a country’s products,
demand for the and thus its currency. $
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
also invest taxpayer money to increase the overall pension fund.

How it works have retired. Governments need meet current and future liabilities is
to ensure there is enough money key to the successful management
In most countries, it is the current to go around, a task that is all the of state pensions.
working generation that is funding more challenging because in most
the pensions of those who have developed countries the population Managing
reached retirement age, as well as is ageing, which means that fewer investments
the pensions of those who are due workers are funding the pensions
to retire. This is the case in the of an increasing number of older In countries with state-owned investment
UK, where National Insurance people. Measuring how well funds, the government invests taxpayers’
contributions from current workers pension funds are likely to
go towards pensions for those who contributions to increase the available
money in the fund. Investment is usually in
Managing contributions core assets, which are less risky but can still

In some countries, such as Chile and Japan, and at state level in the fluctuate. If stock markets rise, so do
US, pension managers invest the funds collected from taxpayers pension funds, and vice versa.
with the aim of keeping the amount of available money sufficiently
high to meet predicted demand. In other countries, any surplus in INVECSOTMREENTS
the pension fund (such as the National Insurance Fund in the 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” ❯❯Over-investment in equity contributions are invested.
(stocks and shares), which can These are not always in the
Elizabeth Warren, US politician promise high returns, poses a best interests of the pension
potential risk to any pension pool or its future ability to
fund, and can be especially make payments. In some
damaging to state pension countries, a percentage of
funds. Japan discovered this pension contributions are lent
after the nation’s Government to the government for other
Pension Investment Fund lost purposes, or invested in public
5.6 per cent 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.
PENSIONERS

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 from
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