2.6 - Macroeconomic Objectives and Policies Flashcards
Possible macroeconomic objectives
- Economic growth
- Low unemployment
- Low and stable inflation
- Balance of payment equilibrium on the current account
- Balance government budget
- Protection of the environment
- Greater income equality
Demand-side policies
Government policies aimed at influencing aggregate demand to achieve macroeconomic objectives like growth, low unemployment, and stable inflation
Expansionary policy
A demand-side policy used to boost aggregate demand and stimulate economic growth, typically during a recession or negative output gap
Contractionary policy
A demand-side policy used to reduce aggregate demand and control inflation, typically during a boom or positive output gap
Monetary policy
The use of interest rates, money supply, and exchange rates by a central bank (e.g., the Bank of England) to influence aggregate demand and achieve macroeconomic objectives
Fiscal policy
The use of government spending and taxation to influence aggregate demand and achieve macroeconomic objectives like economic growth, low unemployment, and price stability
Expansionary monetary policy
- Lower interest rates, encourages borrowing and spending
- Increase money supply, more liquidity in the economy
- Weaker exchange rate, boosts exports and reduces imports
Contractionary monetary policy
- Raise interest rates, discourages borrowing and spending
- Reduce money supply, limits excess liquidity
- Stronger exchange rate, reduces inflation but makes exports less competitive
Expansionary fiscal policy
- Increase government spending on infrastructure, healthcare, and education
- Cut taxes to raise disposable income and encourage consumption and investment
Contractionary fiscal policy
- Decrease government spending, to cool down an overheating economy
- Increase taxes, to reduce disposable income and limit inflation
Limitations of monetary policy
- Liquidity trap, if interest rates are already very low, further cuts may not encourage borrowing or spending
- Time Lags, changes in interest rates take 12-24 months to fully impact the economy
- Interest rate insensitivity, consumers and businesses may not respond to lower rates if confidence is low (e.g., during a recession)
- Conflict with other policies, fiscal policy (government spending & taxation) may counteract monetary policy effects (e.g., government austerity could limit Aggregate Demand growth despite low interest rates)
Limitations of fiscal policy
- Budget deficits and national debt, expansionary fiscal policy (higher spending or tax cuts) can lead to higher government debt, which may require future tax increases or spending cuts
- Inflationary pressure, excessive government spending can cause demand-pull inflation, reducing purchasing power
- Political constraints, governments may make decisions based on political popularity rather than economic necessity (e.g., avoiding tax increases before elections)
- Effectiveness depends on multiplier, if the fiscal multiplier is low (e.g., due to high imports or low confidence), the impact of fiscal policy may be weaker than expected
Quantitative Easing
A form of expansionary monetary policy where a central bank (e.g., the Bank of England) creates new money electronically to buy financial assets, such as government and corporate bonds
Positive effects of Quantitative Easing
- Lower Interest Rates, Quantitative Easing increases the money supply, reducing interest rates and making borrowing cheaper for consumers and businesses
- Weaker exchange rate, more money in the economy can depreciate the currency, making exports more competitive
- Higher asset prices, Quantitative Easing raises demand for financial assets (e.g., bonds, stocks), increasing their prices and creating a wealth effect that encourages spending
Negative effects of Quantitative Easing
- Inflation risk, excessive Quantitative Easing can overstimulate demand, leading to demand-pull inflation
- Inequality, wealthier individuals benefit more from rising asset prices, increasing income inequality
- Asset bubbles, Quantitative Easing boosts financial markets, potentially leading to overvaluation of assets (e.g., stocks, real estate)
Budget surplus
When government revenue (taxes) exceeds government spending over a specific period, leading to a positive fiscal balance
Budget deficit
When government spending exceeds government revenue (taxes) over a specific period, leading to increased borrowing
Direct taxes
Taxes levied directly on individuals or businesses based on income, profits, or wealth, such as income tax, corporation tax, and inheritance tax
Indirect taxes
Taxes levied on goods and services, such as VAT, excise duties, and sales tax, which are paid by consumers through higher prices
Great Depression
In the 1930s, the world experienced a severe depression known as the Great Depression, in the UK unemployment was over 15% and in the US it was almost 25%. The areas most affected in the UK were the primary industry and the manufacturing industry which relied on exports and so were impacted by the collapse of world trade
Causes of the Great Depression
- Stock market crash (1929), a major collapse in share prices led to panic selling and a loss of wealth and confidence
- Bank failures, many banks collapsed due to loan defaults, reducing money supply and causing a credit crunch
- Protectionism and trade barriers, policies like the Smoot-Hawley Tariff (1930) reduced international trade, worsening the downturn
Policy responses to the Great Depression in the UK
- Abandoning the Gold Standard (1931), the UK left the gold standard, allowing the pound to depreciate, making exports more competitive and boosting economic growth
- Fiscal austerity, the government cut public sector wages and unemployment benefits to reduce the budget deficit, but this worsened unemployment in the short run
- Interest rate cuts, the Bank of England lowered interest rates to 2%, reducing borrowing costs and encouraging investment
Policy responses to the Great Depression in the USA
- The New Deal, introduced by President Franklin D. Roosevelt, the New Deal aimed to provide relief, recovery, and reform through government intervention
- Monetary policy, the US left the gold standard, allowing the dollar to depreciate, making exports more competitive and increasing the money supply
Global Financial Crisis
A severe worldwide economic crisis triggered by the collapse of the US housing market and banking system, leading to a credit crunch, recession, and government bailouts
Causes of the Global Financial Crisis
- Subprime mortgage collapse, banks issued high-risk subprime loans in the US, leading to massive defaults
- Housing market bubble, easy credit and speculation caused housing prices to soar, followed by a sharp crash
- Bank failures and credit crunch, major banks collapsed (e.g., Lehman Brothers, 2008), leading to a loss of confidence and reduced lending
Policy responses to the Global Financial Crisis in the UK and the USA
- Both governments were forced to nationalise banks and building societies and guarantee savers their money in order to prevent the chaos of a collapsed banking system. For example, the British government bought Northern Rock and most of Royal Bank of Scotland and Lloyds Bank
- They used expansionary monetary policies with record low interest rates and quantitative easing. The Bank of England said the QE led to lower unemployment and higher growth than would otherwise have been the case
Supply-side policies
Policies aimed at increasing the productive capacity of the economy by improving efficiency, competition, and incentives in markets. These policies shift the long-run aggregate supply (LRAS) curve to the right, leading to sustainable economic growth
Market based policies
Policies that aim to increase efficiency and economic growth by reducing government intervention and allowing free market forces to operate more effectively
Interventionist policies
Policies where the government actively intervenes in the economy to improve productivity, infrastructure, and human capital, leading to long-term economic growth
Examples of market based policies
- Increase incentives, reducing income and corporation tax to encourage spending and investment and/or reducing benefits to increase the opportunity cost of being out of work
- 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 - Reform the labour market, reducing trade union power makes employing workers less restrictive and it increases the mobility of labour, making the labour market more efficient
Interventionist policies
- Promote competition, a stricter government competition policy could help reduce the monopoly power of some firms and ensure smaller firms can compete
- Reform the labour market, governments could try and improve the geographical mobility of labour by subsidising the relocation of workers and improving the availability of job vacancy information
- Improve skills and quality of the labour force, the government could subsidise training, lowering costs for firms, since they will have to train fewer workers or spend more on healthcare to help improve the quality of the labour force and contributes towards higher productivity
- Improve infrastructure, governments could spend more on infrastructure, such as improving roads and schools
Strengths of of supply-side policies
- Unlike demand-side policies, supply side policies are able to both increase output and decrease prices
- More long-term policies and lead to long term economic growth, rather than small changes in economic growth following changes in Aggregate Demand
- Can be directed at increasing exports which will also improve the balance of payments
Weaknesses of supply-side policies
- The Keynesian Long Run Aggregate Supply curve shows that they have no impact when Long Run Aggregate Supply is elastic, and so demand-side policies are needed to fix the problem in the short run
- Not all supply side policies work at actually increasing supply, whilst others cause conflicts and both these issues vary depending on which policies are used
- Often the government has to spend more money (for example on education) or decrease taxes, which will decrease their revenue and lead to a budget deficit
Conflicts and trade-offs between objectives
- Economic growth vs. Protection of the environment
- Economic growth vs. Balance of Payments
- Unemployment vs Inflation
Conflicts and trade-offs between economic growth and protection of the environment
As 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. Economic growth in China has been rapid but it has led to serious levels of pollution
Conflicts and trade-offs between economic growth and 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
Conflicts and trade-offs between unemployment and inflation
In the short run, there is a trade-off between the level of unemployment and the inflation rate, illustrated with a Phillips curve. As economic growth increases, unemployment falls due to more jobs being created. However, this causes wages to increase, which can lead to more consumer spending and an increase in the average price level
Conflict and trade-offs between policies
- Expansionary and deflationary fiscal and monetary policies
- Changes in interest rates
- Supply-side policies
- Fiscal deficits
Conflict and trade-offs between expansionary and deflationary fiscal and monetary policies
Expansionary policies will increase AD, to increase output, employment and economic growth but will lead to increased inflation and may worsen the balance of payments as some of the increased demand for goods and services will be met by imports. On the other hand, deflationary policies will decrease AD to improve inflation but will decrease employment and economic
growth
Conflict and trade-offs with changes in interest rates
An increase in interest rates will be used to decrease inflation. However, continuously high rates will damage long-term investment as less businesses will want to invest, and this will decrease long-term growth. Moreover, they will raise the value of the pound which will decrease exports and increase imports, worsening the balance of payments. Whereas, low interest rates tend to increase income inequality, as the richest people hold a
larger proportion of their wealth in non-money assets, such as stocks, shares and belongings and so aren’t affected much by interest rates
Conflict and trade-offs with supply-side policies
Supply side policies intend to increase aggregate supply, and
therefore improve long term economic growth. They are also able to decrease long term inflation but may increase it in the short term if they encourage investment as this will increase Aggregate Demand. Moreover, policies which decrease trade union power, reduce wages, lower benefits, change taxation etc. may increase income inequality as these will negatively affect the poorest in the country
Conflict and trade-offs with fiscal deficits
In order to reduce fiscal deficits, the government may decide to reduce government spending and increase taxes. Firstly, this will reduce Aggregate Demand and decrease short term economic growth and higher unemployment. Also, the 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
