2.6 Macroeconomic objectives and policies

Question 1

Describe the macroeconomic objective of economic growth.

Answer 1

In the UK, the long run trend of economic growth is about 2.5%. Governments aim to have sustainable economic growth for the long run.

Question 2

Describe the macroeconomic objective of low unemployment.

Answer 2

Governments aim to have as near as full employment as possible. They account for frictional unemployment by aiming for an unemployment rate of around 3%. The labour force should also be employed in productive work.

Question 3

Describe the macroeconomic objective of low and stable inflation.

Answer 3

In the UK, the government target for inflation is 2%, measured by the Consumer Price Index (CPI). This aims to provide stability for firms and consumers and will help them make decisions for the long run.

Question 4

Describe the macroeconomic objective of having a balance of payment equilibrium on the current account.

Answer 4

If a country has a balance of payment equilibrium on the current account, it allows the country to sustainably finance the current account, which is important for long term growth.

Question 5

How do governments manage demand?

Answer 5

The governments manage demand through monetary and fiscal policy.

For example, in a recession, they often increase AD to increase employment and economic growth. However, in a boom, they will decrease AD to decrease inflationary pressures. They may also use supply side policies, which aim to bring about long-term economic growth.

Question 6

What is expansionary policy aimed at?

Answer 6

Expansionary policy is aimed at increasing AD to bring about growth.

Question 7

What is deflationary policy aimed at?

Answer 7

Deflationary policy aimed at decreasing AD to control inflation.

Question 8

What is monetary policy?

Answer 8

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.

Question 9

What is fiscal policy?

Answer 9

Fiscal policy is the use of borrowing, government spending and taxation to manipulate the level of aggregate demand and improve macroeconomic performance.

Question 10

What is the interest rate?

(Monetary policy)

Answer 10

The interest rate is the price of money and the Monetary Policy Committee (MPC) are able to change the official base rate in order to control inflation. This is called the repo rate, the rate the Bank of England will charge for short-term loans to other banks or financial institutions. A change in the repo rate affects market rates offered by banks to consumers and businesses as the Bank of England is the lender of last resort.

Question 11

What is the effect of the interest rate increasing the cost of borrowing for firms and consumers?

(Monetary policy)

Answer 11

The rise in interest rates will increase the cost of borrowing for firms and consumers. This will lead to a fall in investment and consumption, reducing AD as investment and consumption are components of AD (AD = C + I + G + (X-M). Two particular areas of consumption that will decrease are consumer durables and houses.

Question 12

What is the effect of less people borrowing and more people saving?

(Monetary policy)

Answer 12

Savings are more attractive, as the interest earnt on them will be higher. Since less people are borrowing and more are saving, there is a fall in demand for assets such as stocks, shares and government bonds. This leads to a fall in prices for these assets. Therefore, consumer will experience a negative wealth effect since the value of their assets will fall, which will lead to a fall in consumption. Moreover, investment is less attractive since firms are likely to see lower profits if prices fall. With this being the case, AD falls because of a fall in consumption and investment which are components of AD (AD = C + I + G + (X-M).

Question 13

What is the effect on foreigners if the UK has higher interest rates?

Answer 13

Higher interest rates will increase the incentive 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 demand for pounds and the value of the pound will rise. This means imports will be cheaper, and exports will become more expensive. This decreases net trade and therefore AD.

Question 14

What is the problem of using interest rates to change AD?

Answer 14

-Changes in interest takes up to 2 years to have their full effect and small changes in interest rates may not affect people’s decisions.

-The exchange rate may be affected rate so much that exports fall significantly and imports rise significantly, causing a balance of trade deficit.

-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, not matter how low interest rates are, consumers and businesses do not want to borrow or banks do not what to lend to them.

Question 15

What is the problem of having high interest rates over a long period of time?

Answer 15

High interest rates over a long period of time will discourage investment and decrease LRAS.

Question 16

What is quantitative easing?

(Monetary policy)

Answer 16

Quantitative easing is when the Bank of England buys assets in exchange for money in order to increase money supply and increase the flow of money in the economy during times of very low demand.

‘Quantitative’ means the set amount of money is being created and ‘easing’ refers to reducing pressure on banks

It can prevent the liquidity trap, where even low interest can’t stimulate AD.

Question 17

What is the effect of quantitative easing?

Answer 17

Quantitative easing has the effect of increasing consumption and investment, which increases AD and ensures the country meets its inflation target.

Question 18

Explain how quantitative easing works.

(asset prices)

Answer 18

Since the bank is buying assets, there is a rise in demand and so asset prices rise. This causes a positive wealth effect since shares, houses etc. are worth more so people will increase their consumption. Moreover, the cost of borrowing will decrease as higher asset prices mean lower yields (money earnt from assets), making it cheaper for households and businesses to finance spending.

Question 19

Explain how quantitative easing works.

(money supply)

Answer 19

The money supply increases. Private sector companies receive more money which they can spend on goods and services or other financial assets, which may increase investment or consumption and therefore increase AD.

It may push asset prices further up. Banks have higher reserves, meaning they can increase lending to households and businesses so both consumption have investment increase as people can buy on credit.

Question 20

What are the problems associated with quantitative easing?

Answer 20

-It is very risky, if not controlled properly, it could cause high inflation and even hyperinflation.

-There is no guarantee that higher asset prices lead into higher consumption through the wealth effect, especially if confidence remains low.

Question 21

What was the effect of quantitative easing on the housing market?

Answer 21

Quantitative easing had a large effect on the housing market by stimulating demand and leading to rapid price increase since 2013, helping to worsen the issues of geographic mobility. It also led to share prices which increase rising inequality, since the rich grow richer whilst the poor see none of the gains.

Question 22

How can monetary supply be controlled by the central bank?

(A rebuttal for disadvantages of quantitative supply)

Answer 22

The central bank can force banks to hold certain assets as a percentage of their total assets, known as monetary base or reserve assets. This means they can control the amount of money that is loaned and therefore the money supply.

Question 23

Explain the two main ways the government can change AD through fiscal policy?

Answer 23

-A rise in income tax will cause a fall in disposable income. This will lead to a reduction in consumption and thus 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.

Question 24

Direct taxes are…

Answer 24

paid to the government by the individual taxpayer.

Question 25

What is a indirect tax?

Answer 25

An indirect tax is where the person charged with paying money to the government is able to pass on the cost to someone else i.e. the supplier can pass on the burden to indirect tax to the consumer.

Question 26

What are the four taxes raise the most government revenue?

Answer 26

-Income tax

-National insurance

-VAT

-Corporation tax.

Question 27

What are some points about income tax in the UK?

Answer 27

-Income tax is a direct tax and is the biggest source of revenue for the government (around 25% of all taxation revenue).

-Personal allowance for income tax is set at £12, 570 for 2024/25.

-The basic rate is 20%, the higher rate is 40% and 45% is the additional rate for income over £150 000.

Question 28

What are the problems of fiscal policy?

Answer 28

-Government spending also impacts LRAS. For example, by cutting spending to reduce AD, the government may be reducing the quality of education or spending on research and technology.

-Taxes and spending have an impact inequality (…).

-The government also has to worry about political issues, for example they may be unwilling to raise taxes in order to reduce demand as this may lead to them being voted out the government.

-The impact of fiscal policy depends on the multiplier: the bigger the multiplier, the bigger the impact of AD.

Question 29

What are some points about VAT?

Answer 29

-VAT is an indirect tax and the standard rate of VAT is 20%. Not all goods pay the the standard rate, for example, food and children’s clothes aren’t charged and domestic fuel & power are charged at 5%.

Question 30

What are the issues classical and Keynesian economists have with demand-side policies?

(evaluation of demand-side policies)

Answer 30

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 an increase in AD during a depressions will be purely inflationary.

On the other hand,

On a Keynesian LRAS, the impact of changes in AD depend on where the economy is operating: if the economy is operating at full employment (full capacity) then a rise in AD will only lead to higher price. However, if unemployment is very high, then a rise in AD will only lead to higher output.

Question 31

What is the biggest issue of demand-side policies?

Answer 31

Although a changes in price/output depends on the elasticity of the LRAS curve, in most cases, an expansionary policy is inflationary whilst a deflationary policy brings unemployment. Thus, through demand management, the government cannot bring about low and stable inflation AND high economic growth/low employment.

Question 32

Why is monetary policy useful?

Answer 32

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.

Question 33

Using an example, how can fiscal policy have significant impacts on the supply side of the economy?

Answer 33

An increase in spending on education to increase AD will increase LRAS.

Question 34

Using an example, when is fiscal policy more effective?

Answer 34

Fiscal policy is more effective at targeting specific groups and reduce poverty, for example by increasing benefits it can increase AD and reduce poverty.

Question 35

What are supply-side policies aimed at?

Answer 35

Supply-side policies are government policies aimed at increasing the productive potential of the economy and moving supply curve to the right.

Question 36

What are market based policies?

(Supply-side policies)

Answer 36

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 and a lack of risk-taking.

Question 37

What are interventionist polices?

(Supply-side policies)

Answer 37

Interventionist policies are designed to correct market failure, for example 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 government may take actions to encourage investment.

Question 38

What is the effect of increasing the size of the workforce?

Answer 38

An increase in size of the workforce means that more goods and services will be produced.

Question 39

What incentives can the government use to increase the size of the workforce?

(Supply-side policies, benefits)

Answer 39

-The government can reduce benefits, a reduction in benefits will increase the opportunity cost of being out of work and mean that people are always better of within work than on benefits. Unemployment trap??

Question 40

What incentives can the government use to increase the size of the workforce?

(Supply-side policies, taxes)

Answer 40

Taxes on firms when they take new staff, such as National Insurance Contributions, decrease the incentive for businesses to employ. Reducing these taxes would increase incentives for firms to employ. Furthermore, a reduction in corporation tax would incentivize for firms to invest, as firms will see a bigger return on their investment.

Question 41

What is the problem on using taxes to increase the size of the workforce?

Answer 41

The problem with this methods is that many people will argue a small change in any tax, for example from 25% to 20%, will have little impact on people’s incentive to work.

Also, reductions of tax on high income earners will lead to more income inequality and any reduction will mean government have less revenue so have to decrease spending or borrow more. Reducing benefits will also affect equality.

Question 42

How can the government promote competition?

(Supply-side policies)

Answer 42

The government can promote competition through:

Privatisation , selling nationalised companies to private sectors, or deregulation. Reducing restriction on businesses which restrict entry to the market, makes firms more competitive. Competition is necessary to make firms efficient as they have to offer a cheap or better service if there is competition. Free market economists argue that governments have little incentive to cut costs or innovate so nationalised industries are inefficient and causes government failure.

Question 43

What is the problem through privatisation or deregulation?

(Supply-side policies)

Answer 43

Deregulation and privatisation may lead to poorer quality service. It could also cause environmental issues if deregulation is seen in environmental regulations.

Question 44

How can the government reform the labour market?

(Supply-side policies, weakening of unions).

Answer 44

The labour market could become more flexible in order to make it more efficient as it can respond to external changes, such as changes in demand for a production or population changes.

One way the government can do this is through weakening of unions. For example, the government introduced postal ballots, banned secondary picketing and reduced the picket line to only 7 people. This is important as trade unions push up wages which can constrain the level of output that firms can produce due to increased costs. A decrease in the level of output will limit AS, and so therefore reducing their power will hope to prevent this.

Question 45

How can the government reform the labour market?

(Supply-side policy, higher mobility of labour)

Answer 45

Flexibility in the labour market can be improved through increase the mobility of labour. This can be done through increased provision of information about job vacancies, improved flexibility of pensions and improved geographical mobility.

Question 46

What are the problems of weakening trade unions?

(Supply-side policies)

Answer 46

Trade unions are already very weak in the UK so reducing their power further may have little effect.

Question 47

What is the problem of reducing benefits?

(Supply-side policies)

Answer 47

Reducing benefits will lower AD if these people are unable to find jobs, thus causing a further fall in employment. The reduction in benefits is likely to have a multiplied effect as the poor have a very high MPC and so reduction in their income will cause a large fall in spending, meaning AD falls by a lot.

Question 48

What is the problem of making the labour force more flexible?

(Supply-side polcies)

Answer 48

Making the labour force more flexible will lead to decreased quality of life as people are less secure in their jobs and may have to work odd hours. It will also mean that some people receive very low pay, which will increase income inequality and may reduce AD.

Question 49

How can the government improve the skills and the quality of the labour force?

(Supply-side, education and training)

Answer 49

They could increase spending on education and training to create a more educated workforce who will be more efficient and be able to do more skilled jobs, increasing the number of goods and services produced. This could be in terms of academic education, such as free university tuition, more spending on secondary school.

Question 50

What is the problem of improving education?

(Supply-side policies)

Answer 50

However, improving education ma have no effect if it is skills not relevant to the workforce. Increasing education will incur an opportunity cost as it means government money will be lost in other sectors such as healthcare. Lastly, it will also take time to see the effect of increased education, there may be not effect as more investment may no necessarily increase the quality of education.

Question 51

How does location advantage affect trade?

Answer 51

The location of market demand influence trade patterns. It is advantageous for an exporting country to be close to their importing partner to reduce transport costs.

Countries close to the USA have a huge market to sell to. In parallel, being positioned strategically also enhances trade (e.g. South East Asia countries, Malaysia is between India and the Pacific)

Some countries have been able to use their wealth from the export of raw materials to diversify their economy (e.g. Brazil and South Africa). They can trade their goods best to their comparative advantage.