First, Monetary Policy Committee (MPC) can consider a cut in interest rates. With cheaper borrowing, households will be induced to borrow even more to spend. Rise in consumption (C) will shift AD rightward thereby promoting higher economic growth. To produce more goods and services, more manpower will be required. This leads to lower unemployment. At the same time, lower rates will lead to outflow of money. Wealthy foreigners and pension funds would want to seek better return by placing their money in other countries that offer more favourable rates.
Such process, leads to rise in supply of pound in foreign exchange market, thus weakening its value. Somehow, UK’s exports will gain competitiveness ground. This should be able to solve the first imbalances and that is declining manufacturing output and yet a rise in employment Via tax cut, there will be a rise in disposable income. In theory, with more money in hand, working people will have greater tendency to spend into the economy. This will give retail sales a further boost.
At the same time, rise in consumption will contribute to increase in AD hence economic growth. In such period, prospects for average earnings will likely improve since real GDP per capita has increased. As such, the second imbalances which is booming retail sales but sluggish growth of average earnings is said to be resolved It is worth to note that a slash in interest rates may not even work to solve the first imbalances. There are two reasons for this. First, it depends on how large is the cut which may subsequently affects the performance of the pound.
Usually a cut of 0. 25% or even 0. 50% is trivial. Secondly, it is short lived. Economic growth is often accompanied by fast rising inflation. Goods manufactured in UK will soon loose its competitiveness due to rising costs like wages. Subsidies from UK government would be better. It can be spent onto identified ‘desperate’ industries across the nation. It promotes not only job creations but also ensure the survival of factories Income tax cut has many problems too.
It cannot be manipulated frequently, just once a year during the Budget. Unlike monetary policy, it has greater flexibility and responsiveness since MPC members meet every first week of the month. Decision on interest rates will be made public a day after. It is also worth to note changes in the direction of income tax are politically sensitive. It is always easier to cut than to raise income tax rates. There will be times, when politicians need to raise tax once again, especially when the budget deficit is ballooning