2.6 - Macroeconomic objectives and policies Flashcards
What are the macroeconomic objectives? (7)
1- Economic growth: sustainable growth at 2%
2- Low unemployment: Governments aim for an unemployment at 4%
3- Low and stable rate of inflation: Government target is 2%
4- Balance of payment equilibrium on the current account: Avoid large deficits or surpluses in trade.
5- Balanced government budget: spending = revenue, so national debt doesn’t escalate.
6- Greater income equality: This reduces the gap between the rich and the poor.
7- Protection of the environment: It ensures resources are not exploited and that they are used sustainably
What is a Demand-side policy?
It is any deliberate action taken by governments or monetary authorities to shift the AD curve.
What are the two types of demand side policies (with a small explanation) ?
1- Fiscal Policy: the manipulation of government spending and taxation in order to influence AD
2- Monetary Policy: where the central bank or regulatory authorities influences the level of AD, by altering interest rates or the level of money in an economy.
What is an interest rate?
It is the cost of borrowing money or the reward for saving.
What are the 2 monetary policy instruments?
1- Interest rates
2- Asset purchasing
What is the base interest rate?
The base interest rate is the interest rate that the central bank will charge commercial banks for loans.
How are interest rates used to reduce aggregate demand and therefore inflation? (use a AD/AS diagram)
When interest rates are increased the cost of borrowing increases for consumers and firms as repayments of loans rise, the reward for saving increases due to greater repayments. As a result consumption and investment are likely to fall thus reducing AD and decreasing the price level. This is known as a deflationary monetary policy
How are interest rates to increase AD?
The MPC may reduce the base interest rate. This means there is a reduction of the costs of borrowing for consumers and firms, meaning consumption and investment are likely to increase. Additionally saving is less attractive as repayments are lower. As a result AD increases and the price level may increase.
What is Quantitative easing?
It refers to the the purchasing of government bonds or other financial assets in exchange for money by the central bank as a means to increase the supply of money and stimulate the economy.
Explain how quantitative easing can increase AD.
The central bank buys government bonds (or similar assets) from banks and investors in exchange for money it creates electronically.
Banks now have more money which means they can loan more money to consumers and firms. This increases consumption and investment. As AD = C+I+G+ (X-M).
Asset prices rise due to the increased demand. This causes positive wealth effects meaning an increase in consumption. Moreover the rise in asset prices results in the yield falling (yield is the return on a bond), consequently lower interest rates are offered which decreases the costs of borrowing, leading to an increase in spending and thus AD.
What is a problem with quantitative easing?
1- It is very risky and if not controlled properly could cause high inflation
What are the 2 fiscal policy instruments?
1- Government expenditure
2- Taxation
What are the 2 forms of taxation?
1- Direct taxes: taxes on incomes such as income tax and corporation tax.
2- Indirect taxes: taxes on spending such as VAT.
How would Fiscal policy be used to reduce AD?
Reduce government expenditure which is a factor of AD.
Increase taxes: an increase in income tax, would reduce disposable income for consumers and thus reduce consumption. An increase in corporation tax would reduce investment which is a factor of AD.,
How would Fiscal policy be used to increase AD.
Increase government expenditure which is a factor of AD.
Decrease taxes: A decrease in income tax means consumers take home more money and thus consumption increases. A decrease in corporation tax means firms can increase investment.
What is the name for when fiscal policy is used to increase AD?
Expansionary Fiscal Policy.
What us the name for when fiscal policy is used to decrease AD?
Contractionary Fiscal Policy
When does a government budget (fiscal) deficit occur?
When government spending is greater than the revenue it receives from taxation.
When does a government budget (fiscal) surplus occur?
When government spending is less than the revenue it receives from taxation.
Why does AD rise when there is a government budget deficit?
There will be an increase in AD, as a deficit means government spending is greater than taxation, thus implying government spending has increased which is a factor of AD, or that taxation has decreased which means consumers have more income and firms keep more revenue. As a result consumption and investment increase.
Why does AD fall when there is a government budget surplus?
A government budget surplus implies government spending is less the the revenue it receives via taxation. This implies that there is a decrease in government expenditure which is a factor of AD meaning AD will decrease. It may also suggest that taxation has increased which means a decrease in disposable income and thus a decrease in consumption / investment.
What is the role and operation of the Bank of England’s Monetary Policy Committee
The monetary policy committee (MPC) of the Bank of England sets the base interest rates. The MPC meets every month to look at the factors that are likely to influence the rate of inflation over the coming 18 months. As it is a monthly meeting, the MPC votes to determine whether to raise, lower or leave the base interest rate. The MPC is required to use its monetary tools to meet the governments inflation target of 2%. If the target 2% is missed by 1% either side, the Bank of England is required to explain the reasons why and how it intends to restore the rate of inflation to 2%.
What were the causes of the Great Depression of 1929.
The Great Depression was set off by the Wall street crash of 1929 when there was a sharp fall in share prices on the New York stock exchange. Economists had different views in what they believed caused the depression:
1- Loss of consumer and business confidence.
2- Caused by the 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: It reduced world trade which decreased AD and lowered confidence. Firms involved involved in exports were no longer able to pay their bank loans which caused bank failures in the USA. America introduced the Smoot-Hawley Tariff act in 1930 which decreased imports into the USA. Countries which traded with America saw a reduction in exports which decreased AD in their countries. America also faced a fall in exports as other countries retaliated.
4- The UK was affected by its commitment to the gold standard. The re-joining of the gold standard meant the pound was appreciated rapidly and exports fell as they became more expensive. The UK went into the great depression with an overvalued exchange rate.
What were the policy responses to the Great Depression in the USA.
1- The initial response of the US government in 1929 was to do very little. But they believed in balancing the government budget.
2- President Hoover increased 900 import tariffs by between 40% and 48% which probably worsened the Great Depression. And he allowed a limited public works programme.
3- When President Roosevelt came to power in 1933, unemployment had reached 10million, to address this he introduced his New Deal. This involved a looser monetary policy, millions of dollars for infrastructure, a larger public sector and price support for agriculture.
What were the policy responses to the Great Depression in the UK?
1- The government believed that balancing the government budget as key to recovery. They introduced an emergency budget which cut public sector wages and unemployment benefit by 10% and raised income tax by 22.5% to 25%. This reduced AD at a time when it needed to be increased.
2- In 1931, deflationary policies were necessary to maintain the value of the pound. These further depressed GDP.
3- In September 1931, the government left the gold standard, which resulted in a 25% fall in the value of the pound. Monetary policy was also eased with a reduction in interest rates.
4- The UK introduced a 10% tariff on imports from most countries. However, it cut interest rates and increased money supply.
What were the causes of the 2008 Global Financial crisis?
1- The 2008 financial crisis was started by issues in mortgage lending in the USA: in the early 2000s relatively poor people were encouraged by the government and banks to take out mortgages and buy their own homes. Many were no longer able to continue paying. Houses were repossessed, demand fell and prices fell. Meaning the value of the houses is less than the mortgage.
2- Banks were grouping ‘prime’ mortgages and ‘sub-prime’ mortgages and selling them to investors as if they were ‘prime’ mortgages. This caused a fall in confidence.
What were the policy responses in the USA towards the 2008 financial crisis.
1- Fiscal Policy: tax cuts and increase in public expenditure amounted to $700 billion.
2- Monetary Policy:
- Interest rates were cut from 5.25% to
0.25%.
- Quantitative easing: the central bank
purchased $2.1 trillion of government
bonds to increase money and keep
interest rates low.
What were the policy responses in the UK towards the 2008 financial crisis.
1- Fiscal Policy:
- The government followed an expansionary fiscal policy between 2007 and 2010, which included buying shares in UK banks, a temporary cut in VAT, and bringing forward £3billion in investment.
- The budget deficit increased from 2.3% to 11.3%
2- Monetary Policy:
- Interest rates: the Bank of England cut the bank base rate
- Quantitative easing: over the period 2009 to 2016, the bank of England bought £435 billion of government bonds in an attempt to increase money supply and keep interest rates low.
3- Evaluation:
- Authorities avoided using extreme measures early in the crisis.
- QE helped prevent a more severe recession, but some economists argue that its main effect was to increase asset prices.
What are the strengths of demand-side policies?
1- If the multiplier is large, they can have a significant impact on growth.
2- According to Keynesian economics, demand side policies are the only way to get a country out of demand-deficit unemployment and stagnation (in the short run)
3- If there is spare capacity the economy can grow quickly.
4- If used to control demand pull inflation, they can act quickly and solve the problem.
What are the weaknesses of demand-side policies?
1- According to classical economics, expansionary demand-side policies only cause inflation in the long run.
2- The multiplier might be so low that they have little effect.
3- If there is no spare capacity, then supply-side policies are needed instead in order to achieve economic growth.
4- If used to stimulate AD, the government can end up running a huge budget deficit, which adds to national debt.
What are supply side policies?
Supply-side policies are government policies designed to increase LRAS through measures to increase the productivity and efficiency of the economy.
What are the two types of supply-side policies?
1- Market based supply side policies
2- Interventionalist supply-side policies.
What are Market based supply side policies?
Market based policies are policies which are designed to remove anything which prevents the free market working efficiently. They relate to measures designed to:
1- increase competition
2- increase incentives
3- reduce regulations
What are interventionalist supply side policies?
Interventionalist policies are policies designed to correct market failure. They involve government intervention and are designed to increase productivity.
What are 5 examples of market based policies?
1- Increased incentives for workers, e.g. by cutting income tax or lowering benefits.
2- Labour market reforms, e.g. reducing trade union power.
3- Increased incentives for firms, by reducing corporation tax.
4- Promote competition, e.g. privatisation where nationalised companies are sold to the private sector or deregulation which reduces restrictions on firms entering a market. Competition policy to prevent monopolies
5- Removing regulations that are preventing firms from growing. For instance removing restrictions on mergers.
What are 5 examples of interventionalist policies?
1- Improving the skills and quality of the workforce (human capital). For instance by proving more apprenticeships.
2- Investment into infrastructure, e.g. motorways
3- Investment in new technology
4- Finance for business start-ups.
5- Incentives for investments
Illustrate the effect of a supply side policy
AS1 shifts to AS2 resulting in an increase of RGDP from y1 to y2.
What are the strengths of supply side policies?
1- Economic growth can be achieved without inflationary pressures building up.
2- Some supply side polices help to increase productivity, e.g. privatisation and deregulation
3- They are less likely to cause a conflict with other macroeconomic objectives.
4- They are more long term policies and lead to long term economic growth
What are the weaknesses of supply side policies?
1- If AD is very low then supply-side policies would have no impact on real output.
2- Interventionalist policies might be very expensive, e.g. new infrastructure projects such as HS2
3- Many supply side policies take a considerable time to work, e.g. improvements in education and training.
4- Some supply side policies, e.g. lower welfare benefits and lower income tax rates might increase income inequality.
When does a trade off occur?
A trade off occurs when an objective is achieved only at the expense of some other objective.
What are the 3 conflicts between objectives?
1- Inflation and unemployment
2- Economic growth and the environment
3- Inflation and the balance of payments
How does the government trying to control the rate of inflation lead to unemployment?
When the government tries to control the rate of inflation is is likely to try to reduce AD. Less spending means less pressure on prices. The government may increase taxes. This will cause a fall in inflation and AD. Firms may start laying off workers because they are unable to sell all their goods/services. As workers are laid off, incomes fall and the cycle continues.
How can the trade off between inflation and unemployment be illustrated?
The Phillips curve. With inflation on y-axis and unemployment on x-axis. It is a curved downwards slope.
Explain how the conflict between economic growth and the environment exists.
As the economy grows we expect more resources to be used. As we use resources and produce goods we produce pollution, noise and destroy habitats.
Explain the conflict of inflation and the balance of payments
The actions required to control inflation can damage the current account. For example, raising interest rates to reduce the rate of inflation might have the effect of raising the inflation rate, which makes exports expensive and imports cheap.
What are the 3 conflicts between macroeconomic policies?
1- Fiscal policy and monetary Policy
2- Monetary policy and supply side policy
3- Supply-side policy and fiscal policy
