1
Q
key macro objectives
A
- low and stable inflation
- sustained growth of real gdp
- low unemployment
- higher mean living standards
- balance trade on the current account of payments
- achieve more equitable distribution of income/ wealth
- protection of the environment
2
Q
3 broad categories of macroeconomic policy:
A
- Fiscal policy: policies that involve government spending, taxation, and/or borrowing to affect AD
- Monetary policy: policies relating to interest rates, the money supply, and/or the exchange rate
- Supply side policy: policies that increase the productive potential of an economy; usually in relation to increases in the quantity and/or quality of an economy’s factors of production
3
Q
Budget (Fiscal) Deficit
A
The difference between what the government receives in revenue and what it spends
4
Q
Cyclical Fiscal Deficit
A
The size of the deficit is influenced by the state of the economy: in a boom, tax receipts are relatively high and spending on unemployment benefit is low
5
Q
What is fiscal policy?
A
- fiscal policy is use of govt spending, direct/indirect taxation to affect level and growth of AD, output and jobs
- used to change pattern of spending on goods and services
6
Q
what are three justifications for government spending?
A
- provide socially efficient level of public goods and overcome one or more market failures
- infrastructure provision
- manage level and growth of AD
7
Q
direct taxes vs indirect taxes
A
direct - levied on wealth, income and profit
indirect - taxes on spending
8
Q
Changes in employers’ national insurance affect the cost of
A
employing extra workers
9
Q
- Changes in VAT affect business
- Changes in direct taxes can influence work
- Changes in business taxes might affect the level of foreign
- taxes can affect the incentive to start
A
costs
incentives
direct investment
a business
10
Q
fiscal surplus =
A
gov spending< tax revenues
11
Q
fiscal deficit =
A
tax revenues< govt spending
12
Q
What is government borrowing?
A
- Public sector borrowing is the amount the government must borrow each year to finance their spending.
- Usually this borrowing is achieved by the sale of government debt, known as bonds.
13
Q
What is national debt?
A
• Public sector (government) debt is a measure of the accumulated debt owed by the government sector.
14
Q
Causes of a budget (fiscal deficit)
A
anything that results in less tax paid or increase in welfare benefit spending
eg, recession, decrease consumer spending, increase in economic inactivity
15
Q
Keynesian economists believe that fiscal policy is the most
A
effective form of managing demand, output and confidence at times of economic instability.
16
Q
Discretionary fiscal changes
A
deliberate changes in direct and indirect taxation and govt spending
17
Q
Automatic stabilisers
A
changes in tax revenues and government spending that come about automatically as
an economy moves through the business cycle
18
Q
What is fiscal austerity?
A
Austerity is when the Government uses contractionary fiscal policy to decrease their budget deficit. The primary aim is not to decrease AD but to slow the rate of growth of the national debt.
19
Q
Policies to reduce the size of a budget (fiscal) deficit
A
- cuts in government spending
- higher taxes
- supply side policies to encourage growth
20
Q
What is Monetary Policy?
A
- Monetary policy involves changes in interest rates, the supply of money & credit, and exchange rates.
- The Monetary Policy Committee (MPC) of the Bank of England has full operational independence.
- In the UK, tools of monetary policy are changes in interest rate and supply of money.
21
Q
what is the exchange rate of £ determined by
A
entirely by demand and supply in international foreign exchange
markets
22
Q
MPC only sets
A
base rate, other little banks set own interest. rates on products, but these often follow changes in bank of Englands base rate
23
Q
Monetary Stability
A
- Monetary stability means stable prices and confidence in the currency.
• Stable prices are defined by the UK Government’s inflation target
24
Q
Expansionary Monetary Policy
A
o Fall in nominal and real level of interest rates.
o Measures to expand / increase the supply of credit from the commercial banking system.
o Depreciation of the external value of the exchange rate
25
Deflationary Monetary Policy:
o Higher interest rates on both loans and savings.
o Tightening of credit supply (i.e. loans become harder to get).
o Appreciation of the exchange rate.
26
Nominal and Real Interest Rates
The real rate of return on savings is the money rate of interest minus the rate of inflation.
27
interest rates falling mean?
- borrowing costs fall
- more spending and investment
- higher AD
= increases real GDP and employment levels in the labour market
28
interest rates rising means?
- slows down consumption = lower AD
- more saving
- mortgagers have less disposable income
29
key roles for central banks (4)
- setting interest rates
- financial regulation
- lender of last resort
- debt management
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Debt management
Handling the issue (sale) and repayment of issues of government debt such as bonds.
31
Policy operation functions:
o “Lender of last resort” to the commercial banking system to provide stability.
o Managing levels of liquidity in the commercial banking system e.g. in the immediate aftermath of an economic shock such as the Global Financial Crisis.
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Financial stability & regulatory function:
o Prudential policies designed to maintain financial stability of banks & other lenders.
33
Monetary policy function
o Setting of the main monetary policy interest rate (i.e. the base rate or bank rate).
o Quantitative easing (QE) – this policy creates extra credit within the financial (banking) system.
o Exchange rate intervention (only with managed/fixed currency systems)
34
what are the factors considered when setting policy interest rates in UK context?
- GDP growth
- consumer confidence
- equity market
- international data
35
What is quantitative easing?
• Quantitative easing (QE) is the introduction of new money into the national money supply by a central bank.
36
four key channels through which QE operates
1. Wealth effect - lower yields (interest rates) lead to higher share and bond prices.
2. Borrowing cost effect - QE lowers the interest rate on long term debt such as government bonds and
mortgages.
3. Lending effect - QE increases the liquidity of banks and increased lending from banks lifts incomes and
spending in the economy.
4. Currency effect - lower interest rates has the side effect of causing the exchange rate to weaken (a
depreciation) which helps exports.
37
difference between monetary financing and quantitative easing?
MF - direct transfer of permanent central bank money to govt
| QE - central bank makes bond purchases
38
currency appreciation =
exports more expensive = lower/inward shift AD
| imports cheaper = outward shift AS
39
Arguments in favour of stimulus policies in the aftermath of the crisis:
1. Prevent an economic depression
2. creates jobs
3. avoid price deflation
4. support confidence
40
Weaknesses / limits to stimulus policies
1. Keynesian liquidity trap
2. moral hazard
3. impact on savers
4. rising property prices
41
Demand-side policies can have supply-side effects:
1. Cuts in direct taxes on income can stimulate an increase in the labour supply
2. Increased government spending on regional growth such as financing special economic zones can lead to an influx of foreign indirect investment which increases LRAS
3. Reductions in indirect taxes can increase short run aggregate supply and increase operating profits
4. Infrastructure spending increases the capital stock and increases capacity in telecoms, transport & energy
42
What are supply-side policies?
• Policies that improve the productive potential of an economy. This is Illustrated by an outward shift of LRAS
43
what are the different approaches to supply side reforms?
- market led policies: designed to make markets work better and give the private sector more freedom
- state/ government intervention in markets to overcome market failures
44
What are the main aims / objectives of supply-side policies?
1. improve incentives to look for work
2. increase labour productivity
3. increase occupational and geographical mobility of labour
4. increase investment and r&d spending
5. promote competition
45
Examples of interventionist supply-side policies
- investment into public services and infrastructure
- higher taxes on the wealthy
- management of exchange rate to improve competitiveness
- selective import controls
46
Human capital can be improved by
- growth in grades attainment
- increased access to quality in work training and opportunities
- inflow of above average skilled migrants
47
The biggest barriers to innovation are:
* Risk aversion – research is often highly expensive whilst rewards are uncertain.
* Uncertainty about firms’ ability to exploit research profitably.
* A lack of high-skilled workers in key research industries.
48
policies to attract FDI
- SEZ zones
- low rates of corporation tax
- low unit labour costs
- soft loans and tax reliefs
49
Examples of such market-led policies include:
- cutting govt spending and borrowing
- lower business taxes, for more capital investment spending
- lower income tax rates to improve work incentives
- Opening up an economy to inward skilled labour migration.
50
Possible drawbacks of market-led supply-side policies
1. lower taxes does not always improve work incentives
2. reduction in progressive direct taxes may = increase in income and wealth inequality
3. Deregulating markets can lead to increasing instability
51
Potential conflicts between objectives
as tradeoffs or choices might have to be made
1. Unemployment/ inflation – Phillips Curve analysis
2. Economic growth and inflation – overheating economy with excess AD = demand-pull inflation.
3. Economic growth and the balance of payments – a consumer boom may cause the trade deficit to rise as demand for and spending on imports grows faster than income from exports.
4. Economic Growth and Inequality – the benefits from economic growth are not evenly distributed.
5. Per capita income vs environmental degradation - rapid growth = increased pollution, long-term damage to natural capital
6. Income inequality vs Economic growth - does high inequality causes slower long-term growth?
52
The potential conflict between economic growth and inflation
o The risk of accelerating inflation is greatest when short run aggregate supply is inelastic i.e. When the economy has low spare capacity.
o If an economy suffers high inflation and a slowdown in economic growth – this is called stagflation.
o The conflict between growth and inflation can be resolved by having effective supply-side policies.
53
The potential trade-off between economic growth and the balance of payments
rise in income(consumers and firms - raw materials) =. more imports = worsens trade balance
depreciate exchange rate to counter
54
Potential trade-off between economic growth and the stock of environmental assets
- waste
- climate change risk
- depletion of natural capital
- loss of biodiversity
55
philips curve shows relationship between
inflation and unemployment
56
Elastic Phillips Curve – Spare Capacity
* When unemployment rate is high, wage pressures in labour market are low – workers have low relative bargaining power because they can be replaced by someone willing to work at lower wages.
* There is plenty of spare capacity in the labour market such as many unfilled jobs vacancies.
* Fears over job security might lead to workers being unwilling to bid for higher wages.
57
Inelastic Phillips Curve – Capacity Constraints Take Effect
* As unemployment falls, labour shortages may cause an increase in wage inflation and higher unit labour costs.
* When an economy is booming, so does the derived demand for and prices of components and raw materials – leading to higher costs.
* Rising demand and falling unemployment can lead to suppliers raising prices to increase their profit margins.
* Workers have relatively more bargaining power, because they are a scarce resource and in demand by firms
58
Fall in the Natural Rate of Unemployment
* The natural rate of unemployment is known as the equilibrium rate of unemployment.
* It is estimated by adding to together frictional + structural unemployment.
* These policies = fall in the natural rate of unemployment
* = long run Phillips Curve to shift to the left
* = country is better able to maintain lower inflation whilst cutting the rate of unemployment
59
Why might there have been an improved trade-off between unemployment and inflation?
1. Improved labour mobility and incentives
2. Impact of skilled migration into the labour market
3. Reduced worker bargaining power / rise of monopsony employers
4. Effects of globalisation / technological change on consumer prices
60
Expansionary policy
is aimed at increasing AD to bring about growth, whilst deflationary policy attempts to decrease AD to control inflation.
61
repo rate definition
rate BoE will charge for short term loans to other banks or financial institutions
62
how can rise in interest rates cause a fall in AD (4)
- increase cost of borrowing (investment, consumption), reducing AD
- since less borrowing and more saving, there is a fall in demand for assets, eg stocks, shares an government bonds, leads to a fall in prices for these assets, so consumers experience a negative wealth affect as value of assets fall (c drops)
- less confident about borrowing and spending if interest rates rise, less C and I
- higher rates for increases incentives for foreigners to hold their money in UK banks as higher rate if return = higher demand for pound = vale fo pound rises
63
problems with interest rate management (monetary policy)
- changes in interest rates take up to 2 years to have their full effect and
small changes in interest rates may not affect people’s decisions.
- Sometimes, interest rates are so low that they cannot be decreased any further to stimulate demand
- A lack of confidence in the economy may mean that, no matter how low interest
rates are, consumers and businesses do not want to borrow or banks do not want to
lend to them.
o High interest rates over a long period of time will discourage investment and
decrease LRAS.
64
Quantitative easing:
This is when the Bank of England buys assets in exchange for money in order to increase money supply and get money moving around the economy during times of very low demand.
- can prevent liquidity trap, where even low interest rates can not stimulate AD
65
Quantitative easing has the effect of
increasing consumption and investment, which increases AD and ensures the country meets its inflation target
66
since the bank is buying assets:
there is a rise in demand and so asset prices rise. causes a positive wealth effect since shares, houses etc. worth more so people increase consumption. Moreover, cost of borrowing decrease as higher asset prices = lower yields (money earnt from assets), making it cheaper for households/ businesses to finance spending.
67
money supply increases after quantitative easing, so
Private companies receive more money they can spend on g+s or other financial assets, which increase investment or consumption = increase AD. may also push asset prices up further. Banks have higher reserves, so can increase lending to households + businesses so consumption and investment increase as people can buy on credit.
68
Commercial banks may lower their interest rates as they are receiving so much money from the Bank of England and so
can offer very low interest deals to customers. increased money supply mean that the price of money falls; interest rates are price of money. will encourage borrowing = increase investment and consumption so increase AD. If many banks decide to lower interest rates, same mechanisms will apply as those after a reduction in the base rate.
69
problems with quantitative easing
o very risky, if not controlled properly, could cause hyperinflation
o Others say would only lead to increased demand for 2nd hand goods which
pushes up prices but doesn't increase AD. eg, would not lead to more new houses being built but only 2nd hand houses becoming more expensive.
o no guarantee that higher asset prices lead into higher consumption through wealth effect, especially if confidence remains low.
o also led to rising share prices which increases inequality, since the rich grow richer, the poor see none of the gains.
o not meant to be permanent and there are concerns that banks and economies are too dependent on quantitative easing, particularly within the Eurozone.
70
Role of the Bank of England in monetary policy
Monetary policy is controlled by the Bank of England rather than the government. The Monetary Policy Committee (MPC) makes the most important decisions, including the Bank of England base rate and the actions over quantitative easing.
71
There are two main ways the government can increase AD through fiscal policy:
● A rise in income tax will cause fall in disposable income. lead to a reduction in consumption = decrease AD. Alternatively, a rise in corporation tax will decrease a firm’s post-tax profits. This will lead to a reduction in investment and thus decrease AD.
● A rise in government spending will increase AD since it is one component.
72
Government budgets:
The government’s fiscal (spending, borrowing and taxation) plans outlined in budget. budget deficit is when government spends more money than receive. budget surplus is when the government receives more money than they spend.
73
problems which need to be considered when evaluating fiscal policy;
Government spending also impacts LRAS. eg, by cutting government spending to reduce AD, reduced quality of education or spending on research and technology.
o Taxes and spending have an impact on incentives, eg, high taxes reduce incentives.
o government has to worry about political issues, don't want to get voted out
o Expansionary fiscal policy is difficult to undertake during a period of austerity.
o The impact of fiscal policy depends on the multiplier: the bigger the multiplier, the bigger the impact on AD. Classical economists argue that the multiplier is almost zero whilst Keynesian economists argue that it can be large if targeted correctly.
74
Evaluation of demand-side policies: (classical)
● Classical economists argue that any demand management, whether fiscal or monetary, will have no effect on long-run output so supply side policies should be used. They believe that increasing AD during a depression will have no effect other than to increase prices. If the economy is in short-run disequilibrium, it will quickly return to long run equilibrium
75
Evaluation of demand-side policies: (Keynesian)
On a Keynesian LRAS, the impact of changes in AD depend on where the economy is operating: if the economy is at full employment then a rise in AD will only lead to higher prices. However, if unemployment is very high, then a rise in AD will only lead to higher output
76
Evaluation of demand-side policies:
● Both policies see significant time lags between introduction and full effect.
● biggest issue of demand-side policies is, usually, expansionary policy is inflationary whilst deflationary policy brings unemployment. depends on the elasticity of curve and curve which perceive to be correct (Keynesian or classical), but holds in most scenarios. Thus, through demand management, the government cannot bring about both low and stable inflation and high economic growth/low unemployment.
77
Monetary vs fiscal policy:
- Monetary policy is useful as the government is able to increase demand without having to increase their spending, which would result in a larger fiscal deficit. Classicists argue that if demand management is going to be done only monetary policy should be used.
- Fiscal policy has significant impacts on supply side of the economy, eg, increases in spending on education to increase AD will also increase LRAS. Moreover, it is more effective at targeting specific groups + reduce poverty, eg by increasing benefits can increase AD + reduce inequality.
78
Supply side policies are government policies aimed at
increasing the productive potential of the economy and moving the supply curve to the right. tends to be supply-side improvements through actions of the private sector such as investment. However, the government is able to use supply-side policies in order to increase and speed up these improvements
79
Market based policies are policies which are
designed to remove anything that prevents the free market system working efficiently, causing lower output and higher prices. These barriers include those which reduce willingness of workers to take jobs or lead to inefficient production, high prices or a lack of risk-taking.
80
Interventionist policies are policies designed to
correct market failure, eg, the free market under provides education and so the government provides it. Also, firms may only look into the short term and look to maximise short run profits to give to shareholders instead of investing, so governments may take actions to encourage investment.
81
Free market economists tend to argue for market-based policies as
they want the government to have as small a role as possible. Economists who support interventionist policies suggest the free market is not as efficient as people believe and so the government needs to intervene to improve it.
82
supply side policies examples
```
Increase incentives
Promote competition
Reform the labour market
Improve skills + quality of labour force
Improve infrastructure
```
83
increase incentives
● By increasing the incentive for people to go to work or firms to employ people, the government will increase the size of the workforce and this would mean more goods and services would be produced.
- reduce benefits/ taxes
- encourage parts of workforce back to work like women
- reduction of minimum wage will incentivise firms to employ
84
could increase incentives for people to take risks or for firms to invest
One way they could do this would be lowering taxes, which will mean people see a bigger return on their investment.
85
promote competition
● Privatisation, selling nationalised companies to private sectors, or deregulation, reducing restriction on businesses which restrict entry to the market, makes firms more competitive.
● Competition policy is used to prevent monopolies in the market and make cartels and price fixing agreements illegal
● belief is that competition is necessary to make firms efficient as have to offer a cheaper/better service if competition. Free economists argue governments have little incentive to cut costs or innovate so nationalised industries are inefficient and causes government failure.
● However, deregulation and privatisation may lead to a poorer quality service. It could also cause environmental issues if deregulation is seen in environmental regulations.
86
reform labour market
- By increasing the retirement age, there will be more people working and so more
goods and services could be produced.
- make labour market more flexible, weaken unions, change employment contracts, higher mobility of labour
- reduction of benefits
as whole all methods would reduce unemployment which represents a waste of resources, so more g+s can be produced as labour force is bigger
87
problem with using these methods to reform labour market
- trade unions are already very weak in the UK
- reducing benefits will lower AD if these people are unable to get jobs and this will cause further fall in employment.
- reduction in benefits likely to have a big effect as poor have very high MPC so a reduction in income will cause large fall in spending, meaning AD falls by a lot.
- It may also mean there is increased income inequality.
- Making labour force more flexible lead to decreased quality of life as people less secure in jobs + may have to work odd hours. It
88
improve skills and quality of labour force
- increase spending on education and training
- introduce regulation which forces businesses to continuously train their own staff
- increase in high skilled migrants would also improve quality of workforce
overall: improvements in skills mean workers are more efficient and so can produce more g+s + develop new technology
BUT improving education have no effect if it in skills irrelevant to the workforce. Increasing education incur an opp cost as means gov money be lost in other sectors. will also take time to see effects of education and more investment may not necessarily increase quality of education
89
improve infrastructure
- tax incentives or subsidies on investment. eg, businesses who invest their profits could see lower tax rates.
- government could spend money themselves
BUT: Offering tax/subsidies have adverse effects on the gov budget as it mean lose tax rev/ incur an opp cost as they spend money on subsidies. Some may not actually invest this money and instead used as a method of tax evasion.
90
Evaluation of supply-side policies:
● Unlike demand-side policies, supply side policies are able to both increase output + decrease prices.
● more long-term policies and lead to long term economic growth, rather than small changes in economic growth following changes in AD.
● Moreover, can be directed at increasing exports which will also improve the balance of payments.
- supply side policies allow market based and interventionist policies
BUT: Keynesian LRAS curve shows that they have no impact when LRAS is elastic, and so demand-side policies are needed to fix the problem in the short run.
91
negatives of supply side policies
● not all supply side policies work at increasing supply, others cause conflicts and both issues vary depending on which policies are used.
● gov has to spend more money (eg, on education) or decrease taxes, which will decrease their rev and lead to a budget deficit.
● These actions may also have undesirable impacts on AD and could cause higher unemployment or higher inflation.
● Supply side policies can also take a long time to have any effect on output and this makes them less useful.
92
Economic growth vs. protection of the environment
s the economy grows, we expect more resources to be used. As we use resources and produce goods, we produce pollution and noise and destroy habitats
93
Economic growth vs. Balance of Payments
Some countries such as India have seen rapid economic growth leading to balance of payments problems. The country is so large that its industry is largely producing goods for its own people and the wealth of the people has led to increased demand for imported goods
94
Expansionary and deflationary fiscal and monetary policies
Expansionary policies increase AD, to increase output, employment and Econ growth but lead to increased inflation and worsen BOP as some of increased demand for g+s will be met by imports. On the other hand, deflationary policies will decrease AD to improve inflation but will decrease employment and economic growth
95
Changes in interest rates
increase in interest rates be used to decrease inflation.
- but continuously high rates will damage long-term investment as less businesses will want to invest, and this will decrease long-term growth.
- will raise value of pound which decrease exports and increase imports, worsening BOP.
- Low interest rates increase income inequality, as richest people hold larger proportion of wealth in non-money assets, such as stocks, shares and belongings and so aren’t affected by interest rates, whilst middle and working-class people are more likely to have savings in the bank.
96
Fiscal deficits:
- In order to reduce fiscal deficits, the gov may decide to reduce gov spending and increase taxes.
- Firstly, will reduce AD and decrease short term economic growth and higher unemployment.
- Also, higher the fall in output as a result of these measures, the higher the fall in tax revenues will be and so therefore the more ineffective the policy.
- Moreover, it is likely to affect income equality as the poor are the ones who use the government services most and so will be worst affected.
Econ AS
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