2.6 - macroeconomic objectives and policies Flashcards
2.6.1 - [ possible macroeconomic objectives]
all 7 possible macroeconomic objectives?
-economic growth
-low unemployment
-low and stable rate of inflation
-balance of payments on the current account
-balanced gov budget
-protection of the environment
-greater income inequality
economic growth?
~a central macroeconomic aim
~target of 2%
~2% is considered sustainable growth –> less likely to cause demand pull inflation
~has positive impacts on confidence, consumption, investment, employment, incomes, living standards and gov budgets
low unemployment?
-UK target is 4-5%
-this is close to full employment level of labour
-there will always be a level of frictional employment
-unemployment tends to be inversely proportional to real GDP growth
low and stable rate of inflation?
-UK target of 2% using consumer price index [CPI]
-low rate indicates economic growth
-different causes of inflation require different response from the gov
-high inflation rates reduce the purchasing power of consumers
-low and stable inflation allows confidence in planning investments and price stability
balance of payments on the current account?
-the BoP for a country is a record of all the financial transactions related to exports and imports that occur between that country and the rest of the world
exports > imports = surplus
exports < imports = deficit
-deficits cause a problem in the long run
balanced government budget?
-the gov budget is presented annually and includes the forecasted revenue and expenditure
-
protection of the environment?
-in April 2021, the UK gov stated their environmental aim was to reduce emissions by around 78%
~broader environmental aims include ;
a focus on sustainability
100% energy from renewable sources
greater income inequality?
-high levels of income inequality creates social unrest
-perfect income equality is not desirable as it removes the incentive to work
-unchecked capitalism has a natural outcome of high income inequality
-concentration of ownership becomes more narrow
2.6.2 - [demand-side policies]
what do demand-side policies aim to do?
-aim to shift aggregate demand
2 main categories of demand-side policies?
-fiscal policies
-monetary policy
what is fiscal policy?
-involves the use of gov spending and taxation to influence AD
-gov are responsible for fiscal policy
-adjusting government spending or taxation in order to effect the macroeconomy. Fiscal policy is undertaken by the government administration.
what is monetary policy?
-involves adjusting interest rates and the money supply to influence AD
-bank of England responsible for for setting monetary policy
-adjusting the supply or price of money in order to effect the macroeconomy. Monetary policy is usually undertaken by the Central Bank.
2 main monetary policy instruments?
-incremental adjustments to interest rates
-quantitative easing which increases the money supply in the economy
transmission mechanism?
the process(es) by which changes in monetary policy end up affecting the real the economy.
Policy tools or “instruments?
these are the specific actions taken by the bank or government in order to affect the economy.
Lowering Interest Rates?
Encourages borrowing and spending by consumers and businesses, stimulating economic growth.
Raising Interest Rates: ?
Discourages borrowing and spending, aiming to cool down an overheated economy and control inflation.
Short-term Impact interest rates?
Immediate influence on borrowing costs and economic activity.
Long-term impact interest rates?
Influences expectations about future inflation and economic condition
A rise in interest rates causes a fall in AD through four key mechanisms:
-increase costs of borrowing
-less confidents
-rise in the value of the pound
Increased MPS/
Decreased MPC
A rise in interest rates causes a fall in AD through three key mechanisms: increase in borrowing costs
This will lead to a fall in investment , reducing AD. . Higher interest rates require higher rates of return for investment. It also makes savings more attractive, as the interest earnt on them will be higher
A rise in interest rates causes a fall in AD through four key mechanisms: Increased MPS/
Decreased MPC
Increased MPS/
Decreased MPC
= decreased consumption as less spending so decrease in AD
A rise in interest rates causes a fall in AD through
four key mechanisms: less confident
-less confident about borrowing and spending if interest rates
rise. The fall in consumer and business confidence leads to a fall in consumption and
investment, causing a fall in AD. On top of this, other loans, such as mortgages, will
become more expensive to repay and so consumers have to dedicate more of their
income to paying back these debts. This means they have less income to spend on
goods and services, so consumption will fall, causing AD to fall.
A rise in interest rates causes a fall in AD through
four key mechanisms: rise in the value of the pound
higher 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 that imports
will be cheaper, and exports will be more expensive. This decreases net trade and
therefore AD.
problems with changing interest rates?
-Time lags - Delayed Effects: Monetary policy decisions, especially those involving interest rates, may take several months to fully impact the economy. For example, changes in interest rates can take time to influence consumer spending and business investment.
Uncertainty: Time lags make it difficult to predict the exact impact of monetary policy, potentially leading to over- or under-reactions.
-Liquidity Trap: When interest rates are very low, further reductions may have little effect on stimulating demand, as people and businesses may prefer to hold onto cash rather than spend or invest it.
Deflationary Pressures: In a deep recession, deflation can set in, making monetary policy less effective as consumers and businesses delay spending in anticipation of lower prices.
what is a Liquidity Trap?
A situation in which low or zero interest rates fail to stimulate economic activity.
what is quantitative easing?
The Central Bank can create new money and then “swap” it (or “asset purchase”) bonds held by Banks.
These banks now have more money
They therefore want to lend it out hence increasing the supply of money.
Therefore, leading to a decrease in the market rate of interest rate.
BoE creates new money to buy bonds.
New money increases money supply
Increased money supply lowers interest rates.
Lower interest rates change:
Consumption
Investment
Exchange rates
supply of money shifts right
What are the main aims of quantitative easing?
The main aims of quantitative easing are to support the level of aggregate demand so that real output can be maintained and inflation can be kept close to the published target.
how does QE work in the currency market?
. An increase in the supply of money with domestic interest rates falling may lead to an outflow of hot money from the commercial banking system to other countries (in search of a better return) and this may cause the exchange rate to depreciate. A weaker currency has a net expansionary effect on aggregate demand (e.g. through an increase in net exports).
Arguments for quantitative easing (UK context)
Important for the central bank to have additional policy instruments other than changing interest rates especially if the economy is experiencing a liquidity trap
Use of QE likely to have staved off the threat of a deflationary depression post 2008. Without QE, the fall in real GDP would have been deeper and the rise in unemployment greater.
Lower long term interest rates have kept business confidence higher and given the banking system extra deposits to use for lending
There are two main ways the government can increase AD through fiscal policy…
- 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.
when are the govs government’s fiscal (spending, borrowing and taxation) plans announced?
outlined in the budget.
A budget deficit is when the government spends more money than they receive. A budget
surplus is when the government receives more money than they spend.
Direct taxes?
- are paid directly to the government by the individual taxpayer
indirect tax?
Indirect tax
is where the person charged with paying the money to the government is able to pass on the
cost to someone else
Depending on the PED and PES producers are able to pass on a proportion ofthe indirecttax
to the consumer
The lower a consumer spends the less indirect tax they pay
There are problems which need to be considered when evaluating fiscal policy
Government spending also impacts LRAS. For example, by cutting government
spending to reduce AD, the government may be reducing the quality of education or
spending on research and technology.
o Taxes and spending have an impact on inequality, so some decisions aimed to
reduce/increase demand may increase income inequality. They also have an impact
on incentives, for example high taxes reduce incentives.
The impact of fiscal policy depends on the multiplier : the bigger the multiplier, the
bigger the impact on AD.
what do classical economists argue about demand side policies?
, 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, whilst Keynesians argue that it can be in long-run
equilibrium for years.
Keynisian LRAS; opinions on demand side policies?
On a Keynesian LRAS, the impact of changes in AD d epend 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.
any other disadvantages of demand-side policies?
Both policies see significant time lags between their introduction and their full effect.
● The biggest issue of demand-side policies is that, in most cases, an expansionary
policy is inflationary whilst a deflationary policy brings unemployment. This
depends on the elasticity of the curve and the curve which you 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.
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 can have significant impacts on the supply side of the economy, for
example increases in spending on education to increase AD will also increase LRAS.
Moreover, it is more effective at targeting specific groups and reduce poverty, for
example by increasing benefits it can increase AD and reduce inequality.
expansionary demand-side policies?
Demand-side policies that aim to increase aggregate demand are called expansionary policies
Expansionary monetary or
causes of the great depression?
1-it may have been caused by the loss of consumer and business
confidence: shareholders lost money in the crash, others became worried about
what would happen, and firms cut back investment which led to a downward spiral in
AD.
2-US banking system . Banks had lent too
much during the 1920s, which had created an unsustainable boom and the system
was unable to deal with issues following the crash
3- Protectionism may also have been another cause of the Great Depression. It
reduced world trade which decreased AD and lowered confidence. Firms involved in
exports were no longer able to pay bank their loans, which caused bank failures
4- The UK was also affected by its commitment to the gold standard, in which its
currency was fixed to the value of gold and therefore fixed to other currencies.
Policy responses in the UK: [great depression]
The UK government believed that balancing the government budget was key to
recovery and that borrowing money would prevent the private sector from doing so.
They introduced an emergency budget which cut public sector wages and
unemployment benefit by 10% and raised income tax from 22.5% to 25%. This
reduced AD at a time when it needed to be increased.
-The pound came under attack from speculators and needed to be defended to
prevent the UK being forced out of the gold standard. A balanced budget meant the
UK didn’t have to borrow from abroad, which helped the exchange rate as did the
high interest rates used to defend the high exchange rate. However, the high
interest rates also decreased demand.
● The UK was forced to leave the gold standard on 21st
September 1931 due to
continued speculation against it. This caused the value of the pound to fall by 25%
compared to other currencies and allowed the Bank of England to cut interest rates
by 2.5%, both of which helped the increase AD by increasing exports or increasing
consumption/investment.
Policy responses in the USA:
[great depression]
-● The US government originally had the same view over a balanced budget as the UK.
● However, Franklin Roosevelt was elected in 1932 with his New Deal which promised
public sector investment, work schemes for the unemployed and fiscal stimulus.
● The USA reached full employment in 1943 (two years after joining the war- the same
as Britain). Roosevelt’s New Deal is an example of Keynesian expansionary fiscal
policy but can be argued it was not large enough to be successful, although it did
have a large impact as the US unemployment figure was so high.
