2.6 Macroeconomic objectives and policies Flashcards
What are the 4 key macroeconomic objectives
- Economic Growth - sustainable in the long-run
- Low Unemployment - as low as possible, 3% only frictional
- Low and stable inflation - 2% targetm
- Balance of Payments Equilibrium on the Current Account - sustainablity of current account to finance deficits; avoid current account
What are some other macroeconomic objectives
- Balanced government budget: This ensures the government keeps control of state borrowing, so the national debt does not escalate. This allows governments to borrow cheaply in the future should they need to and makes repayments easier.
- Protection of the environment: This aims to provide long run environmental stability. It ensures resources are used sustainability
- Greater income equality: This minimises the gap between the rich and poor. It is generally associated with a fairer society.
Is a deficit on the balance of payments
- a high level of imported goods provides consumers with a wider choice of goods, which may be of higher quality and lower prices
○ All of this enhances consumers standards of living and welfare - Firms may also benefits from cheaper or higher quality imported components or raw materials, which may reduce costs, either enhancing profits or lowering prices further for customers
- As a result, it is viewed by many economists that a deficit on the balance of trade overall, is not necessarily detrimental to the wider economy
What is monetary policy
Monetary policy is 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.
What is fiscal policy
Fiscal policy is use of borrowing, government spending and taxation to manipulate the level of aggregate demand and improve macroeconomic performance.
How does an rise in IR cause a fall in AD
increase the cost of borrowing for firms and consumers
It also makes savings more attractive, as the interest earnt on them will be higher
fall in demand for assets such as stocks, shares and government bonds. This leads to a fall in prices for these assets (negative wealth effect)
People will become less confident about borrowing and spending if interest rates rise.
value of the pound will rise . This means that imports
will be cheaper, and exports will be more expensive. This decreases net trade
therefore AD.
What are some problems with a rise in interest rates
- Such a significant fall that there is a BOP deficit
- Time lag takes 1-2 years effect
- Not all IR affected by repo rate
- Liquidity trap e.g. 2008
- High IR over time encourage discourage investment
How does QE increase AD and inflation to meet the target
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.
there is a rise in demand and so asset prices rise - positive wealth effect
money supply increase; increased money supply will mean that the price of money falls; interest rates are the price of money
Commercial banks may lower their interest rates
What are some issues with quantative easing
- Risky and could cause hyperinflation; 2020 QE –> 2022 inflation
- no guarantee that higher asset prices lead into higher consumption through the wealth effect, especially if confidence remains low.
- More expensive housing market, worsens inequality. It also led to rising share prices which increases inequality, since the rich grow richer whilst the poor see none of the gains.
Evaluate issues with fiscal policy
- Spending impacts LRAS
- Taxes and spending have an impact on inequality
- May have an impact on debt and expectations
- Ricardian Equivalence
- Poor information. Fiscal policy will suffer if the government has poor information
- Dependent on multiplier and confidence
- Size
- Conflicts with other objectives
- Political influence
Evaluate with demand-side policies as a whole
- Classical economist believe its just short-run disequilibrium, will return to LR equilibrium
- Impact of changes on economy depend on where they are in Keynsian Economy
- Significant time lag till full effect
*
Policy response in the UK to the Great Depression
- Contractionay Fiscal Policy
cut public sector wages and unemployment benefit by 10% and raised income tax from 22.5% to 25%; reduces AD - UK forced to leave gold standard, caused value of £ to fall by 25%,
- There was recovery in London and the South East but Wales, the north and Scotland
did not reach full employment until 1941.
What was the US policy response to the Great Depression
Expansionary Keynsian fiscal policy response
- New Deal which promised public sector investment, work schemes for the unemployed and fiscal stimulus.
- The USA reached full employment in 1943
What are automatic stabilisers
· Automatic stabilisers act in an automatic way to blunt off the worst extremes in the economic cycle.
· Automatic stabilisers ‘buy time’ for discretionary government policy..
What are the 2 tools of automatic stabilisers;
- Progressive Income Tax System
- Welfare Benefits (U Benefits)
Explain the function of automatic stabilisers in a boom and bust
BOOM (Cushion Demand)
- Higher Incomes –> Workers Pushed into higher tax bands –> Higher average rate of tax –> slow down increase in C
- U low –> Gov. Spending on Benefits reduces
Recession (support output)
1) Incomes Lower –> workers move into lower tax bands –> lower average rate of tax –> Prevents large decrease in C
U High –> Gov. Spending on benefits increase
What does MIT say about the crowding in effect of $1 public investment
$1 of additional public funds for R&D translates into $5 of extra R&D funded by the private sector at the mean values of public and private R&D.
What are the 3 reasons for the crowding in effect
- Frontier technology projects have extremely high fixed costs .
- “Spillover effects”, where new technologies find different applications e.g. GPS was public sector
- Credit constraints on the private sector, where a project is difficult to fund without government support due to, say, an economic downturn.
What is the liquidity trap
Occurs when the base rate falls so low that it no longer stimulates AD.
Following the credit crunch banks became nervous/very cautious about lending and limited the availability of credit as they sought to recoup losses.
What is forward guidance
· Forward guidance is when the Central Bank announces to markets that it intends to keep interest rates at a certain level until a fixed point in the future.
The aim of forward guidance is to influence long term interest rates and market expectations
What are the benefits of forward guidance
· Commercial banks feel the cut in base rates is temporary, they may not want to cut their long term rates.
· But, if the Central Bank confirms that it will keep base rates at 0.5% for a considerable time, then commercial banks may be more willing to reduce their long term rates because they know they will be able to borrow from the Central Bank at 0.5%.
· The hope is that this will encourage banks to cut rates, and increase overall lending in the economy.
How credible is forward guidance
· There is nothing to stop the Central Bank ignoring its own pledge
· Markets and banks know this and this could reduce the usefulness of the commitment, but it can still give an indication of how monetary policy will operate.
Markets do tend to place a lot of weight on Central Bank pronouncements.
How could forward guidance backfire
· Some economists suggest that a commitment to keep interest rates low for a long time, is an admission that the economy is deeply depressed and this could actually knock confidence and expectations
Therefore, rather than boosting lending and economic activity, forward guidance could be seen as an act of desperation and therefore not help
What is the funding for lending scheme
· The funding for lending scheme was launched in July 2012 to try and encourage banks to lend directly to the real economy
FLS works by Bank of England lends commercial banks funds at interest rates lower than market rates for an extended period.
· If commercial banks expand their lending, they get lower interest rates. However, if they reduce their lending, they have to pay higher interest rates.
· Because commercial banks find it cheaper and easier to borrow – this encourages them to lend to firms and consumers higher quantities and at lower interest rates.
What is the cash reserve ratio and how can it be used for monetary policy
Cash Reserve Ratio, it is the** percentage of deposits which commercial banks are required to keep as cash according to the directions of the central bank.
**
When the central bank wants to increase money supply in the economy, it lowers the reserve ratio. As a result, commercial banks have higher funds to disburse as loans, thereby increasing the money supply in an economy
Evaluate the effectiveness/limitations of monetary policy
- limited in addressing cost push inflation domestically
- limited supply-side effect
- Liquiditty trap
- Need more tools to control this many objectives
- Exports less competitive
- Time Lag- transmission mechanism
What are the arguments for using indirect taxation
· Changes in indirect taxes can change the pattern of demand by varying relative prices (e.g. an increase in the real duty on petrol)
· Indirect taxes can be used as a means of making the polluter pay and “internalizing the external costs” of production and consumption
· Indirect taxes are less likely to distort choices between work and leisure and have less of a negative effect on work incentives.
· Indirect taxes can be changed more easily than direct taxes – this gives policy-makers more flexibility.
· Indirect taxes are less easy to avoid
· Indirect taxes provide an incentive to save that help to provide finance for investment
What are the arguments against use of indirect taxation
· Many indirect taxes make the distribution of income more unequal because of their regressive effects
· Higher indirect taxes can** cause cost-push inflation** which can lead to a rise in inflation expectations
· If indirect taxes are too high – this creates an incentive to avoid taxes through “boot-legging”
· Revenue from indirect taxes can be uncertain particularly when inflation is low or there is a recession causing a fall in consumer spending
· There is a loss of welfare from duties e.g. loss of producer & consumer surplus
· Higher indirect taxes affect households on lower incomes who are least able to save
What is the supply-side effect of lower income tax
increase incentive to work this is because the opportunity cost of not working increases. The voluntary UE may now seek employment meaning the labour supply increase shifting out the LRAS.
· In addition those in work may now work harder as the potential rewards are greater.
Evaluate the effects of a lower income tax
· Given the state of current government finances, can it lower Y tax sufficiently to influence the voluntary Un to find employment. -Liz Truss
· Will those in work harder or just enjoy a post-tax pay rise? - backward bending supply curve
Have the voluntary Un actually got the skills to become employed without retraining?
What is the supply-side effect of decreasing coporation tax
This should create the incentive to invest. As well as influencing AD, the SRAS will be influenced through greater productivity and LRAS increases through increased productive capacity.
Evaluate the supply side effect of lowering coporation tax
· By lowering corporation tax there is no guarantee that firms will invest. They may lack confidence
* Firms may reward shareholders from the greater profits, benefitting AD (as long as the majority of shareholders reside domestically) but not influencing LRAS significantly.
e.g. 18.7 billion water company profit, 18.1 billion dividend
What is the Laffer Curve
The Laffer Curve states that if tax rates are increased above a certain level, then tax revenues can actually fall because higher tax rates discourage people from working.
Equally, the Laffer Curve states that cutting taxes could, in theory, lead to higher tax revenues.
Equally increasing tax rates could yield lower tax revenue due to decreased economic activity, incentives to evade and avoid, brain drain effect
Explain this diagram
Fiscal policy is cumbersome and can overshoot targets.
If the negative output gap is less than expected and or the multiplier stronger than expected a negative output gap could turn positive leading to inflationary expectations.
Monetarists believe that expansionary FP is essentially inflationary.
Why is context so key to fiscal policy
· A key issue of expansionary fiscal policy is the state of the economy. If expansionary fiscal policy is pursued when the economy is close to full capacity (e.g. AD3 to AD4), then the increased government borrowing is likely to cause crowding out and/or contribute to higher inflation – but little increase in real GDP.
In a deep recession, with spare capacity in the economy, expansionary fiscal policy won’t cause crowding out or inflation. (AD1 to AD2 causes real GDP to rise from Y1 to Y2.)
What are the benefits of supply-side policies
- Lower inflation.
-
Lower unemployment; help reduce structural,
frictional and real wage unemployment. - Improved economic growth.
- Improved trade and balance of payments. By making firms more
competitive, they will be able to export more.
What are the general limitations of supply-side policy
- Productivity growth depends largely on private enterprise and trends in technological innovation
- Market Based: equity
- Can be counterproductive
e.g. Since 2009, UK has seen a fall in structural unemployment due to more flexible labour markets- but productivity is almost stagnant - In a recession, supply side policies cannot tackle the fundamental problem which is lack of aggregate demand
- Time. All supply side policies take a long time to have an effect e,g, education spending may not influence the economy for 20-30 years
- Expensive –> large opportunity cost
- Government failure due to assymetric information
What is the policy conflict between inflation and unemployment
Phillips found the existence of an empirical regularity, which said that the rate of change in money wages increased as the rate of unemployment fell. This was then generalised into a relationship
between unemployment and inflation
e.g. Lawson Boom, 1989 2.3% GDP Growth, 7.8% inflation
Evaluate the policy of inflation and unemployment
However, during the 1970s , we saw high levels of unemployment
and low inflation, called stagflation; short-run relationship not right
The Great Moderation 1993-2007, had a long period of economic expansion (36 consecutive quarters)
Relationship has returned to the long-run position
What is the monetarist view of the Phillips curve
argue that in the long run there is no trade-off as Long Run AS is inelastic.
Monetarists argue that if there is an increase in aggregate demand, then workers demand higher nominal wages. When they receive higher nominal wages, they work longer hours because they feel real wages have increased.
but when they realise real wages are the same as last year, they change their price expectations, and no longer supply extra labour and the real output returns to its original level.
Therefore, unemployment remains unchanged, but we have a higher inflation rate. The short-run Phillips curve shifts upwards to SRPC 2
