2.6 - Macroeconomic objectives and policies Content Flashcards
2.6 Macroeconomic objectives and policies
REBEL BELLS: (Macroeconomic objectives).
Regional Equality.
Economic growth. (2%)
Balanced Budget.
Environment.
Living Standards.
Balanced and stable trade.
Equality
Low unemployment (4-5%)
Low and stable inflation (2±1%)
Stability.
2.6 Macroeconomic objectives and policies
Differences between fiscal and monetary policy:
Who controls - gov vs central bank.
FREQUENCY OF ADJUSTMENT:
Fiscal = yearly, monetary = monthly.
2.6 Macroeconomic objectives and policies
What is a deflationary policy?
Fiscal or monetary policy aimed at reducing AD (reduced demand-pull inflation).
2.6 Macroeconomic objectives and policies
Interest rates as a monetary policy instrument
5 effects / reasons why interest changes effect AD and its components
- The rate of interest is the price at which it costs a borrower to lend from a money market
- The rate of interest has a number of effects on AD:
-
Consumer durables
-> many consumers purchase durables such as kitchens and cars on credit meaning if interest is lowered it is cheaper to buy such durables and therefore demand (AD) will increase -
Housing market
-> Houses are almost always bought using a mortage meaning lowered interest rates make monthly repayments cheaper
-> Will encourage sale and purchase of property -> increased demand will result in more houses being built which is classified as increasing investment
-> Those buying a new house / upgrading also likely to buy new furniture therefore increasing consumption -
Saving
-> Increased interest results in greater interest being paid out into saver accounts meaning saving becomes more attractive relative to spending, this means less is spent into the economy reducing AD -
Investment
-> Investment opportunities financed through loans will suddenly become less profitable due to a rise in interest, this means that firms will cut back or not undergo certain investment plans -
Ex rate
-> Fall in interest rate will cause the exchange rate to depreciate -> more exports & less imports -> increased AD
2.6 Macroeconomic objectives and policies
Pros and cons of demand-side policies
4 in total, generalised
-
Time lags
-> Can take significant time to see the increases in AD
-> Especially big infastructure projects aiming to stimulate demand and employment inevitably take multiple years to construct
-> Policies need to be focussed on increases that can be implemented quickly -
The national debt
-> Increasing the deficit in order to finance expansionary fiscal policy to stimulate AD will clearly cause the national debt to increase
->Increases in the national debt can become problematic however in the long run dependant on whether the money was sourced internationally or domestically -
Rate of interest
-> After 2008 financial crash most central banks lowered interest rates to near 0 and yet AD was not stimulated to large degrees leading to the use of QE
-> So interest rates are of limited use -
Size of multiplier
-> Disagreements about its size with classical economists arguing it being close to 0 in the short run meaning
-> Keynesian economists argue that the multiplier can be fairly large if directed carefully eg into depressed industries that hold potential
2.6 Macroeconomic objectives and policies
What is fiscal policy?
Gov. changing taxation and Gov. spending, to influence AD and eco activity.
2.6 Macroeconomic objectives and policies
How can an expansionary fiscal policy be achieved?
Increase G or decrease Taxes.
2.6 Macroeconomic objectives and policies
What does an expansionary fiscal or monetary policy aim to do?
Increase AD
2.6 Macroeconomic objectives and policies
What does an contractionary fiscal policy aim?
Decrease AD
2.6 Macroeconomic objectives and policies
How can a contractionary fiscal policy be achieved?
Decrease G or Increase Taxes
( ↓ AD)
2.6 Macroeconomic objectives and policies
What are limitations to fiscal policy?
- Time lag
- Political costs
- Difficulty forecasting
2.6 Macroeconomic objectives and policies
What is monetary policy?
Use of interest rates + money supply (QE) to influence consumer spending + AD
2.6 Macroeconomic objectives and policies
What are interest rates used for?
To control the supply of money
2.6 Macroeconomic objectives and policies
What are the effects of higher interest rates?
↓ D and ↓ inflation
Or hot money flows inc. investment inc. AD in LR.
2.6 Macroeconomic objectives and policies
What are the effects of lower interest rates?
↑ C ↑ Investment + ↑ Inflation
Investment increases as rate of return on investment AKA Marginal efficiency of capital (MEC) increases AS IT’S CHEAPER TO BORROW
2.6 Macroeconomic objectives and policies
What is the role of the central banks in QE?
- Create money
- Buy bonds from banks
- Increase money supply
2.6 Macroeconomic objectives and policies
What is the role of banks in QE?
- Banks injected with cash
- Increase capital base
- Reduces bond yields
2.6 Macroeconomic objectives and policies
What is the role of borrowers during QE?
- Increased supply of credit
- Increased borrowing = increased spending
- ↑ AD
2.6 Macroeconomic objectives and policies
What are government bonds?
Used to finance national debt + gov’s public sector net borrowing requirement
2.6 Macroeconomic objectives and policies
Who issues gov bonds? Where are they sold?
- Issued by Treasury
- Sold on bond market
2.6 Macroeconomic objectives and policies
What is the safest type of investment?
Government bonds
2.6 Macroeconomic objectives and policies
Give 3 examples of the typical markets for government bonds?
- Pension funds
- Investment trusts
- Private individuals
2.6 Macroeconomic objectives and policies
What will rising interest rates do to gov. bonds?
Rise in i makes bonds less attractive, bond prices fall.
(Inverse relationship of bond prices / interest rates). Due to bonds having a fixed i rate
2.6 Macroeconomic objectives and policies
How does quantitative easing work?
- Central banks creates more money
- Uses money to buy up government bonds and corporate bonds from commercial bands and other financial institutions.
- Because commercial banks now have more cash, it means they can lend it to businesses and consumers.
- Should increase investment and consumer spending. Therefore growth.
- QE also leads to lower interests rates as it increases the money supply –> higher consumption and investment .
- To date, central bank has purchased £895bn
2.6 Macroeconomic objectives and policies
How can QE be evaluated? quantitative easing
- Banks have still been reluctant to lend
-> Initially banks only lent to big companies as seen as less risk
-> Government introduced funding for lending scheme (FLE) (2012)
-> This attached conditions to QE and encouraged lending to SME’s
-> FLE not entirely successful - Consumers and businesses have been reluctant to borrow
-> Consumer and business confidence low after the financial crisis. - Could create inflation
-> Quantity theory of money
-> More money is chasing a limited number of goods. - Could depreciate the currency
-> Therefore, could create imported inflation as prices of imports increase.
2.6 Macroeconomic objectives and policies
What is discretionary fiscal policy?
The deliberate manipulation of government expenditure and taxation to influence the economy
2.6 Macroeconomic objectives and policies
Examples of Supply-side policies: (IRIPI)
- Increase Incentives to supply - Reduce corporation tax
- Reform Labour market - abolish notice period
- Improve labour force quality - ↑ Education, (increases human capital).
- Promote competition - reduce sunk costs - breaks up monopolies.
- Improve Infrastructure - build roads.
2.6 Macroeconomic objectives and policies
What are the best / purest supply-side policies?
The ones which increase LRAS / SRAS with minimal spending.
2.6 Macroeconomic objectives and policies
What are the different ways to classify demand-side and supply-side policies?
Demand-side = fiscal or monetary.
Supply-side = market-based or interventionist.
Either can be expansionary or contractionary.
2.6 Macroeconomic objectives and policies
What does a supply side policy aim to do?
Improve the LR productive potential of the economy.
Pure supply-side policies achieve this with minimal government spending
2.6 Macroeconomic objectives and policies
Market based and interventionist approaches
Define both
- Market-based policies -> aim to remove barries to efficient working of free market eg deregulation
- Interventionist policies -> designed to correct market failure, intervening in free market to improve efficiency directly eg state provision of education due to free market under-provision
2.6 Macroeconomic objectives and policies
What are some main concepts for the objectives of Supply-side policies
- Incentives
- Enterprise
- Technology
- Mobility
- Flexibility
- Efficiency
2.6 Macroeconomic objectives and policies
What are the benefits of higher productivity [6]
- Lower unit costs: Cost savings for businesses can bring lower prices, encouraging higher demand, more output and an increase in employment
- **Improved competitiveness and trade performance (BoP) **
- Higher profits: Efficiency gains are a source of larger profits for companies which might be re-invested, However not all of the profit will be reinvested. It could be payed out to shareholders
- Higher wages: Businesses can afford higher wages when their workers are more efficient
- Economic growth: If an economy can raise productivity then the trend growth of national output can pick up
- Mobility: Productivity improvements mean that labour can be released from one industry and be made available for another
2.6 Macroeconomic objectives and policies
Benefits for objectives of a successful supply side policy
- Achieve a sustained improvement in the possible trade-off between inflation and unemployment (see Phillips Curve)
- Be more flexible in response to external demand and supply-side shocks such as rising energy prices
- Raise living standards through stronger long term economic growth / an increase in underlying trend rate of growth
- Reduce unemployment by lowering the natural rate of unemployment (less frictional & structural unemployment)
- Improve competitiveness in global markets and achieve a stronger balance of trade in goods and services
2.6 Macroeconomic objectives and policies
Evaluation of Supply-side policies
- Supply-side policies have long time lags – especially when they are trying to achieve structural changes
- The level of aggregate demand is also important in making business investment and innovation viable
- Some supply-side policies (e.g. cutting higher-rate income taxes) might lead to greater inequalities of income & wealth
- State intervention to “pick winners” in different industries may be ineffective – there are risks of government failure
- Sustainability issues if policies aim to raise a country’s long term growth rate – leading to increased externalities such as pollution
- Supply-side policies look to achieve relative improvements e.g. In productivity – but other countries will be making gains too
2.6 Macroeconomic objectives and policies
Examples of market-based supply-side policies
- Cutting government spending (including welfare) and borrowing – forces people back to work
- Lower business taxes to stimulate capital investment
- Lower income taxes to improve work incentives – encourages people to get a full time job as they get more money to take home
- Reducing red-tape to cut the costs of doing business – Getting things liscned to sell in the EU and EU and britan have different regulations
- Improving the flexibility of the labour market including reforming employment laws and encouraging more part time work
- Competition policies such as deregulation & anti-cartel laws
- Privatisation of state assets – transferred to the private sector
2.6 Macroeconomic objectives and policies
Examples of government intervention supply-side policies
- State investment in public services and critical infrastructure – energy, electricity, transport and health services
- A commitment to a minimum wage and/or living wage to improve work incentives & productivity in the labour market
- Higher taxes on the wealthy to fund public and merit goods
- An active regional policy to inject extra demand into under-performing areas / regions of persistently high unemployment / low per capita income – e.g. the Government’s Northern Powerhouse Project
- Selective import controls to allow domestic industries to expand – taxes on farming goods to make uk produce more competative
- Management of the exchange rate to improve competitiveness
- Nationalisation of and/or stronger regulation of key industries
2.6 Macroeconomic objectives and policies
5 conflicts between macroeconomic objectives
(inflation, econ growth, unemployment, Current account deficit, fiscal deficit)
- Inflation is too high
-> Assume rate of inflation is too high
-> one way to reduce inflation is to lower AD for example by lowering consumer or gov spending
-> this is likely to lead to a recession meaing economic growth is -ve - Growth is too low
-> Assume rate of economic growth is too low
-> can raise it with AD leading to lower unemployment and increased inflation
-> also likely to increase incomes and therefore imports worsening the current account position (ceteris paribus) which is a conflict - Unemployment too high
-> If unemployment is too high a way of reducing it is to stimulate AD, however this may conflict with policies relating to inflation and the current account - Current account is deeply in the red
-> If imports are far greater than exports then there may be difficulties for an economy in financing this deficit
-> cutting current account deficit by reducing domestic consumption and investment will conflict with unemployment targets - Fiscal deficit too high
-> If gov borrowing is too high a % of GDP gov may raise taxation and reduce spending
-> such measures will inevitably conflict with unemployment objectives
2.6 Macroeconomic objectives and policies
The short run Phillips curve - trade-off between unemployment and inflation
Desribe what the Phillips curve shows and why.
- One example of conflicting macroeconomic objectives
- Describes the statistical relationship between the rate of employment and the rate of change of money wages (Phillps curve) Money wages are the most important cost to producers
- When wage rates increase faster than productivity
-> costs increase for firms
-> they therefore increase their prices
2.6 Macroeconomic objectives and policies
3 conflicts and trade-offs between economic policie
-
Changes in interest rates
-> Gov may use interest rates to influence AD and therefore inflation and unemployment in the short term
-> however persistently high interest rates will damage long term investment and hence long term growth
-> will also likely raise the value of the currency leading to a worsening of the current account -
Supply-side policies
-> Supply-side policies should increase the productive potential of an economy leading to a shift in LRAS and therefore a reduction in inflation in the long run
-> However -> policies that encourage investment in physical capital will lead to higher AD in the short term and therefore increase inflationary pressures -
Fiscal deficits
-> Countries which have fiscal deficits that are too high may attempt to reduce this by cutting gov spending and raising taxes -> will lead to higher unemployment and lower growth in the short term
What is an evaluation to crowding out?
When there is spare capacity, govt. spending could lead to ‘crowding in’, as spending is facilitated through the multiplier.
Crowding out doesn’t occur in a liqudity trap / when secular stagnation theory is present.
What is crowding in?
When higher govt. spending leads to larger private sector investment.
What is crowding out?
When higher government spending, financed by borrowing causes a reduction in private sector investment.
What are the two ways in which crowding out lessens private sector investment?
- More govt. borrowing = more sales of govt. bonds = individuals have less to spend on investment.
- More govt. borrowing = increased interest rates = lower MEC (expected rate of return) on private sector investment.
How can expansionary fiscal policy cause crowding in by the positive multiplier effect?
Induced saving, due to larger eco growth (H-D model).
How can crowding in occur when there is inflation?
Inflation characterised by high interest rates. Govt. spending G. will lessen real interest rates (Loanable funds theory).
(Encouraging private sector investment).
(Inflation also reduces the real value of interest rates).
How do we evaluate the ‘crowding in’ effect during times of deflation?
This is only useful if interest rates are low and ‘sticky’ i.e. liquidity trap.
(During times of deflation, real interest rates are increase, due to fisher equation: real i = nominal i - inflation).
How do we represent the crowding in effect on a diagram?
It is simply the same as the positive multiplier effect:
Give the crowding out diagram (resources):
What is the ‘brain drain’ argument for progressive taxes?
Human capital flight due to excessively high top rate of tax.
Give the laffer curve diagram:
What is Ricardian equivalence theory?
Idea tax cuts financed by govt. borrowing doesn’t change consumption as consumers anticipate future tax increase.
What does Ricardian equivalence assume?
That consumers are rational and realise future taxes will have to rise.
Life-cycle hypothesis - consumers want to smooth their consumption over their lifetime.
Give an example of how life-cycle hypothesis applies to tax rise:
Consumers want to smooth consumption over life time.
Therefore will save following a tax cut in anticipation to pay future tax rise.
(Life-cycle hypothesis is an assumption in the Ricardian theory of equivalence).
Give the influence of tax cuts under Ricardian equivalence diagram:
Describe the Ricardian equivalence diagram
If tax cuts, increase disposable income in the short-term, then it reduces disposable income in the long-term (due to expectations of future tax rises). Therefore, a rational consumer believes their lifetime income is unchanged by a tax-cut.
Give the evaluation diagram to Ricardian equivalence: (Hint economy has to be in recession)!
Spare capacity, so tax cuts incentivise use of spare capacity - (private sector saving). This is crowding in.
What is the poverty trap theory?
If taxes are high, there is little incentive for workers to work and give up benefits.
The rate of economic growth - Accelerator theory
When will the economy grow and not grow
What is the general idea behind the theory
- If the economy is not growing and the same amount is being produced year after year, investment will remain the same
- Firms will only replace depreciated capital but there will be no need to increase beyond this level
- In contrast, if the world economy is expanding, firms will need to increase investment to produce more goods and services
- If in a recession, demand is falling and therefore firms will not need to replace their capital which is wearing out as with lower output less capital is needed -> hence investment will fall in a recession
- Idea that investment is linked to output in an economy is the accelerator theory
How does Real Income influence the trade balance
- Domestic Income: Higher incomes at home boost spending, including on imports, which may worsen the trade balance (e.g., rising U.S. incomes often increase imports from China).
- Foreign Income: Higher incomes abroad drive demand for exports, which can improve the trade balance (e.g., China’s economic growth boosts its imports from Germany and Australia).
How do Exchange Rates influence the Trade Balance
- Depreciation: A weaker currency lowers export costs and raises import prices, boosting the trade balance. Example: Post-Brexit, the depreciated British pound boosted UK exports.
- Appreciation: A stronger currency raises export costs and lowers import prices, hurting the trade balance. Example: The strengthened Swiss franc made Swiss goods more expensive abroad.
