2.6 Macroeconomic Objectives and Policies Flashcards
Main Macroeconomic Objectives
Economic Growth
Low Unemployment
Low and Stable Inflation
Balance of Payments Equilibrium on the Current Account
Macroeconomic Objectives
Economic Growth
In the UK, the long run trend of economic growth is around 2.5%
Governments aim to have sustainable economic growth for the long run
In emerging and developing economies, governments might aim to increase economic development before economic growth, increasing living standards, life expectancy and literacy rates
Macroeconomic Objectives
Low Unemployment
Governments aim to have as near to full employment as possible
They account for frictional unemployed by aiming for an unemployment rate of around 3%
Labour force should also be employed in productive work
Macroeconomic Objectives
Low and Stable Inflation
Government inflation target is 2% in the UK measured by CPI
Aims to provide price stability for firms and consumers and will help them make decisions for the long run
Macroeconomic Objectives
Balance of Payments Equilibrium on the Current Account
Important to allow the country to sustainably finance the current account which is important for long term growth
Other Macroeconomic Objectives
Balance Government Budget
Protection of the Environment
Greater Income Equality
Macroeconomic Objectives
Balance Government Budget
Ensures the government keeps control of state borrowing so national debt does not escalate
Allows governments to borrow cheaply in the future should they need to and mark repayments easier
Macroeconomic Objectives
Protection of the Environment
Aims to provide long run environmental stability
Ensures resources used are not exploited and that they are used sustainably so future generations can access them
Means there is no excessive pollution
Macroeconomic Objectives
Greater Income Equality
Minimises the gap between the rich and poor
Generally associated with a fairer society
Achieving Macroeconomic Objectives
Governments are able to manage demand through monetary or fiscal policy
In times of recession, they often increase AD to increase employment and economic growth
In times of boom, they will decrease AD to decrease inflationary pressures
May also use supply side policies which aim to bring long-term growth
Demand Side Policies
Policies designed to manipulate consumer demand
Expansionary policy is aimed to increase AD to bring about growth
Deflationary policy attempts to decrease AD to control inflation
Types of Demand Side Policies
Monetary Policy
Where the central bank or regulatory authority attempts to control the level of AD by altering base interest rates or the amount of money in the economy
Fiscal Policy
Use of borrowing, government spending and taxation to manipulate the level of aggregate demand and improve macroeconomic performance
Monetary Policies
Interest Rates
Monetary Supply
Role of the Bank of England
Monetary Policy
Interest Rates
Interest rate is the price of money and the MPC (Monetary Policy Committee) are able to change the official base rate in order to tackle inflation
Change in repo rate affects mark rates offered by banks as Bank of England is the lender of last resort
If banks are short of money, they borrow from the Bank of England at the repo rate and therefore they need to make sure their own interest rates are based on the repo rate so they can make a reasonable return
Monetary Policy
Rise in Interest Rates Mechanisms
Increase the cost of borrowing
Fall in prices for these assets
Less confident
Value of the pound will rise
Monetary Policy
Rise in Interest Rates Mechanisms
Increase the cost of borrowing
Rise in interest rates will increase the cost of borrowing for firms and consumers
Leads to a fall in investment and consumption reducing AD
Two particular areas of consumption that decrease are consumer durables and houses
Higher interest rates require higher rates of return for investment
Also makes savings more attractive as interest earned on them is higher
Monetary Policy
Rise in Interest Rates Mechanisms
Fall in prices for these assets
Since people are borrowing and more are saving, there is a fall in demand for assets such as stocks, shares and government bonds
Leads to a fall in prices for these assets
Therefore, consumers experience a negative wealth effect since the value of their assets fall leading to a fall in consumption
Moreover, investment is less attractive since firms are likely to see lower profits if prices fall.
AD falls because of the fall in consumption and investment
Monetary Policy
Rise in Interest Rates Mechanisms
Less Confident
People become less confident about borrowing and spending if interest rates rise
Fall in consumer and business confidence leads to a fall in consumption and investment causing a fall in AD
Other loans will become more expensive to repay and so consumers have to dedicate more of their income to pay back these debts
This means they have less income to spend on goods and services so consumption will fall causing AD to fall
Monetary Policy
Rise in Interest Rates Mechanisms
Value of the pound will rise
Higher rates increase incentives for foreigners to hold their money in British banks as they can see a higher rate of return
As a result, there will be increased demands for pounds and the value of the pound will rise
Means that imports will be cheaper and exports dear
Decreases net trade and therefore AD
Monetary Policy
Interest Rates Problems
Exchange rate may be affected so much that exports fall significantly and imports rise causing a BOP deficit
Changes in interest rates take up to 2 years to have full effect and small changes in interest rates may not affect people’s decisions
Interests rates can be so low that they cannot be decreased any further to stimulate demand
Range of different interest rates and not all of them are affected by the Bank of England base rate
Lack of confidence may mean consumers and borrowers do not want to borrow or banks do not lend
High interests rates discourage investment and decrease LRAS
Monetary Supply
Quantative Easing
This is when Bank of England (BofE) buys assets in exchange for money to increase money supply and move money around economy during times of low demand
Set amount of money is created to reduce pressure on banks
Prevents liquidity trap where low interest rates cannot stimulate AD
BofE increases size of banks’ account at BofE (reserve) encouraging to lend more money
Monetary Supply
Asset Prices
Since bank is buying assets, demand increases, increasing asset prices
Positice welath effect increasing consumption
Cost of borrowing decreases as higher asset prices mean lower yield making it cheaper for households and businesses to finance spending
Monetary Supply
Money Supply
Money supply increases
Private sector receives more leading to more spending on goods and services or other financial assets increasing investment or consumption => AD rises
Also push asset prices further up
Banks have higher reseves so lending increases thus further increasing consumption and investment due to credit
Monetary Supply
Interest Rates
Banks may lower interest rates as they receive so much from BofE so they can offer low deals
Increases money supply thus price of money falls
Encourages borrowing thereforce increase investment and consumption increasing AD
Monetary Supply
Quantative Easing Problems
Risky and could lead to hyperinflation if not controlled
Only increases demand for second hand goods
No guarantee that higher asset prices lead to higher consumption
Rising effect on housing market and share prices
Economies may become too depedent on quantative easing
Role of Bank of England
Monetary policy is controlled by BofE rather than goverment
Monetary Policy Committee (MPC) make most decisions
Aim is to keep inflation at 2%
If inflation drops below 1% or higher than 3% then governor of BofE writes letter to Chancellor of Exchequer explaining and ways to bring to 2%
Fiscal Policy
Increased income tax causes fall in disposable income
Leads to reduction in consumption thus AD
Rise in corporation tax decreases post-tax profits leading to reduction in investment thus AD
Rise in goverment spending increases AD (component)
Government Budgets
Government’s fiscal plans are outlined in budget
Budget deficit is when government spends more than they receive
Budget surplus is when government receives more than they spend
Direct and Indirect Taxation
Direct taxes are paid directly to the government by the individual taxpayer
Indirect tax is where person charged with paying money passes cost to someone else
Income tax, national insurance, VAT, corporation tax
Fiscal Policy Problems
Government spending impacts LRAS
Taxes and spending have an impact on inequality and incentives
Government has to worry about political issues
Expansionary fiscal policy is difficult to undertake during a period of austerity, government needs to consider effect of policies on budget
Demand Side Policies Evaluation
Classical Economists View
Classical economists argue any demand management has no effect on long-run output so supply side policies should be used
Increasing AD during depression has no effect other than increasing prices
If economy is in SR disequilibrium it will quickly return to LR equilibrium while Keynesians argue it takes years to return to LR equilibrium
Demand Side Policies Evaluation
Keynesian Economists View
On a Keynesian LRAS, impact of changes in AD depend on where economy is operating
If economy is at full employment then a rise in AD only leads to higher prices
If unemployment is very high then rise in AD only leads to higher output
Demand Side Policies Evaluation
Time Lags
Both policies see significant time lags between their introduction and their full effect
Demand Side Policies Evaluation
Expansionary Policy
Expansionary policy is inflationary whilst deflationary policy brings unemployment
Depends on elasticity of curve and the curve which you perceive to be correct (K or C)
Thus through demand management, government cannot bring both low and stable inflation and high economic growth/low unemployment
Monetary vs Fiscal Policy
Monetary is only useful as government is able to increase demand without increasing their spending which would result in a larger fiscal deficit
Classicists argue if demand management is going to be done then only monetary should be used
Fiscal policy have significant impacts on supply side
For example, increases in spending on education to increase AD also increases LRAS
More effective at targeting specific groups and reduce poverty
Great Depression
Severe global depression in the 1930s
Unemployment in UK was over 15% and over 25% in US
Areas most affects in UK were primary industry and the manufacturing industry which relied on exports and so were impacted by collapse of world trade
Causes of Great Depression
Confidence
Loss of consumer and business confidence
Shareholders lost money in crash
Others became worried
Firms cut back investments
Led to a downward spiral in AD
Causes of Great Depression
US Banking System
Banks lent too much during 1920s
Causes unsustainable boom
System was unable to deal with issues following crash
Government allowed banks to fail after crash
Decreased confidence further and reduced loans to businesses and consumers
Fall in AD
Causes of Great Depression
Protectionism
Reduced world trade which decreased AD and lowered confidence
Firms involved in exporting were no longer able to pay back loans
Causes bank failures in USA
America introduced Smoot-Hawley Tarrif Act in 1930
Decreased imports to USA
Countries that traded with America saw a reduction in exports causing AD decreases
America also suffered from fall in exports as other countries retaliated
Causes of Great Depression
Gold Standard
UK commitment to gold standard in which its currency was fixed to value of gold and therefore fixed to other currencies
Left gold standard in 1914 but rejoined in 1925 at the 1914 level and value despite value of pound had fallen
Rejoining of gold standard mesnt pound was appreciated rapidly and exports fall as they became more expensive
UK went into Great Depression with an overvalued exchange rate
Policy Responses in UK to Depression
Government Budget
Government believed balancing government budget was key to recovery and borrowing money prevents private sector from doing so
Introduced emergency budget which cut public sector wafes and unemployment benefits by 10%
Raised income tax from 22.5% to 25%
Reduced AD at a time when it needed to be increased
Policy Responses in UK to Depression
Interest Rates
Pound came under attack from speculators and needed to be defended to protect UK being forced out gold standard
Balanced budget meant UK did not have to borrow from abroad helping exchange rate as did the high interest rates used to defend the high exchange rate
High interest rates also decreased demand
Policy Responses in UK to Depression
Gold Standard
UK was forced to leave gold standard on 21st September 1931 due to continued speculation
Caused value of pound to fall by 25%
Allowed BofE to cut interest rates by 2.5%
Helped increased AD by increasing exports or increasing consumption/investment
Policy Responses in UK to Depression
Recovery
Recovery in London and South East
Wales, the north and Scotland did not reach full employment until 1941
Policy Responses in USA to Depression
Government Budget
US government originally had the same view over a balanced budget as the UK
Policy Responses in USA to Depression
New Deal
Franklin Roosevelt elected in 1932 with his New Deal which promised public sector investment, work schemes for unemployed and fiscal stimulus
Policy Responses in USA to Depression
Keynesian Expansionary Fiscal Policy
USA reached full employment in 1943
Roosevelt’s New Deal is an example of Keynesian expansionary fiscal policy but it can be argued it was not large enough to be successful
Although it did have a large impact as the US unemployment figure was too high
Global Financial Crisis (2008/09)
Many parallels between Great Depression and Global Financial Crisis
Both started in US and spread throughout the world and both had large, long term effects on the economy
Global Financial Crisis was less severe than Great Depression
Global Financial Crisis Causes
Morgage Lending
Crisis started by issues in morgage lending in USA
In early 2000s, poor people were encouraged to take our mortgages to buy their homes
Example of moral hazard
Given low interest rates for first few years
Many no longer able to continue paying with higher repayments
Houses were repossessed, demand fell, prices fell thus value of houses was no less than the mortgage of the house
Negative Equity
Global Financial Crisis Causes
Mortgages Types
Banks had been grouping prime mortgages (people likey to pay back loans) and sub-prime mortgages (people unlikely to pay back loans)
Sold packages to other banks and investors if they were all prime mortgages
Aim was to reduce risk since it meant no bank was highly dependant on risky mortgages
Increases risk as many were now holding assets worth less than they had paid for them
Spread effects of the housing crash and unpaid loans
Global Financial Crisis Causes
Confidence
When mortgage grouping was revealed, there was a fall in confidence and banks stop lending between each other fearing they would lose money if the other bank was to collapse
Similar events occured in Europe
Policy Responses in UK and USA to 2008/09
Nationalisation
Both governments forced to nationalise banks and building societies and guarantee savers their money in order to prevent chaos of a collapsed banking system
Policy Responses in UK and USA to 2008/09
Expansioary Monetary Policies
Recorded low interest rates and quantative easing
BofE said the QE led to lower unemployment and higher growth than would otherwise have been the case
Policy Responses in UK and USA to 2008/09
Expansionary Fiscal Policy
USA government had mroe of a expansionary fiscal policy
Perhaps why USA recovered faster
In 2010, UK prioritised reducing National Debt over providing a fiscal stimulus
USA did not make this decision until 2013
Supply Side Policies
Government policies aimed at increasing productive potential of economy and moving supply curve to the right
Over time, tends to be supply side improvements independant of the government through actions of private sector such as investment
Government is able to use supply side policies to increase and speed up improvements
May be across whole economy is in certain markets
Supply Side Policies
Market Based Policies
Policies which are designed to remove anything that prevents 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
Supply Side Policies
Interventionalist Policies
Policies designed to correct market failure
Girms may only look into short term and look to maximise short run profits to give shareholders instead of investing
Government may take actions to encourage investment
Supply Side Policies
Free Market Economists Policies
Free market economists argue for market-based policies as they want government to have as small as a role as possible
Economists who support interventionist policies suggest free market is not as efficient as people believe and so government needs to intervene to improve
Supply Side Policies
Increase Incentives
Increasing incentives to go to work increases size of workforce meaning increased productions
Increase incentives to take risks to invest
People argue small change in any tax has little impact on people’s incentives to work
Reductions of tax on high income earners leads to more income inequality and rediciotns means governments have less revenue leading to decreased spending or increased borrowing
Supply Side Policies
Increase Incentives
Increase Size of Workforce
Reduction in benefits/taxes increases opportunity to work
Reduction in benefits prevents poverty/unemployment trap
Women could be offered free childcare/flexible hours
Taxes on firms when they take on new staff decreases incentivising increased employment
Reduction/removal of minimum wage increases incentives to employ
Supply Side Policies
Promote Competition
Privitisation or deregulation makes firms more competitive
Competition policy used to prevent monopolies and cartels
Belief is that competition is necessary to make firms efficient as have tothey offer cheaper/better service than if there is no competition
However, deregulation and privitisation may lead to poorer quality service and environmental issues
Supply Side Policies
Reform Labour Market
Increasing retirement age increases workforce
Labour market could become flexible to make it efficient to respond to external changes - weaken trade unions, flexibility for chanigng employment contracts, higher mobility of labour
Minimum wage scrapped prevents real-wage inflexibility unemployment
Reduction of benefits incentivies work
However, all methods could have a reverse effect and reduce employment further
Supply Side Policies
Improve Skills and Quality of the Labour Force
Increase spending on education and training - more educated/skilled thus employable workforce
Introduce regulations forcing businesses to continuously train staff
Increase in high skilled migrants improves quality of workforce
Improvements in skill makes workers more efficient
However, education/skills need to be relevant otherwise it is a waste and opportunity cost is set on government as money on education can be spent elsewhere
Supply Side Policies
Improve Infrastructure
Offer tax incentives or subsidies for investment
Government spend money to improve infrastructure themselves
Leads to technological advances thus more efficient
However, tax breaks/subsidies could negatively affect government budget and put government in a deficit
Supply Side Policies Evaluation
Positives
Able to both increase output and decrease prices
More long term policies leading to long term economic growth
Can be direcred at exports improving BOP
Allow two different types of approaches meaning both types of economists accept and use polciies
Supply Side Policies Evaluation
Negatives
Keynesian LRAS curve shows no impact when LRAS is elastic so demand side policies are required to fix problem in SR
Not all supply side policies work at increasing supply
Government increases spending thus budget deficit
Actions may have undesirable impacts on AD causing higher unemployment and inflation
Time lag on effect on output is great
Conflicts and Trade-Offs Between Macroeconomic Objectives
Economic Growth vs Protection of the Environment
As economy grows, more resources are used
As more resources are used, increased production of pollution and noise and destruction of natural habitats
Economic growth can be achieved without damaging environment but growth is likely to be slower and have higher costs
Conflicts and Trade-Offs Between Macroeconomic Objectives
Economic Growth vs Balance of Payments
Some countries have seen rapid economic growth leading to BOP problems
Country is so large that industry is largely producing for its own people and wealth of people led to increased demand for imported goods
Other countries may have increased production for increased exports thus BOP is in surplus
Conflicts and Trade-Offs Between Macroeconomic Objectives
Unemployment vs Inflation - Short Run Phillips Curve
Phillips found a trade-off between inflation and unemployment, Phillips Curve
Found existence of an empiral regularity, rate of change in wages rises unemployment fell
Generalised to relationship between unemployment and inflation by arguing firms can pass on rise in wages to customer by increasing prices
Reason is businesses know if there is high unemployment then low wages can be offered
High employment thus scarcity of skilled labour thus high wages offered
Phillips Curve Model
Initially, the Phillips curve seemed to accurately show the relationship well. However, during the 1970s, we saw high levels of unemployment and low inflation, called stagflation.
Conflicts and Trade-Offs Between Policies
Expansionary and Deflationary Fiscal and Monetary Policies
Expansionary policies increase AD, to increase output, employment and economic growth but lead to increased finlation and worsen BOP as some of increased demand is met by imports
However, delfationary policies decrease AD to improve inflation but will decrease employment and economic growth
Conflicts and Trade-Offs Between Policies
Changes in Interest Rates
Increase in interest rates will be used to decrease deflation
Continuously high rates damage long term investment as less businesses want to invest decreasing long term growth
Value of pound rises, decreasing exports and increasing imports, worsening BOP
Interest rate affects distribution of wealth
Low rates increase income inequality
Conflicts and Trade-Offs Between Policies
Supply Side Policies
Intend to increase AS and therefore improve long term economic growth
Also able to decrease long term inflation but may increase in short term if they encourage investment as this increases AD
Policies which decrease trade union power, reduce eages, lower benefits and change taxation may increase income inequality as these negatively affect poorest in country
Some policies have adverse effects on budget or environment
Conflicts and Trade-Offs Between Policies
Fiscal Deficits
In order to reduce fiscal deficits, government may decide to reduce government spending and increase taxes
Will reduce AD and decrease short term economic growth and higher unemployment
The higher the fall in output, the higher the fall in tax revenues therefore more ineffective they policy is
Likely to affect income equality as poor are the ones who use government services
