2.6 Macroeconomic Objectives & Policies Flashcards
What is monetary policy?
The use of interest rates and money supply to boost AD (and achieve macro objectives e.g growth, inflation)
What are interest rates?
The cost of borrowing money, expressed as a percentage of the amount borrowed
What is contractionary monetary policy?
Involves raising interest rates (and reducing the money supply) in order to reduce the inflation rate
What is expansionary monetary policy?
Involves cutting interest rates or increasing the money supply to boost economic activity
How do high interest rates affect AD?
Higher interest rates increase the cost of borrowing and reduce the value of assets leading to a decrease in AD
What is quantitative easing?
When the central bank buys financial assets e.g government bonds in exchange for money in order to increase borrowing and lending in the economy
How does quantitative easing increase AD?
The commercial bank now holds fewer bonds/loans and more money which it can lend to customers e.g households, firms wanting to invest. This leads to higher investment and consumption
What is the purpose of negative interest rates?
- Increase bank lending: banks more likely to lend than to hold on to money, incentive for consumers/firms to spend and invest, stimulating economic growth
- Combat deflation: incentivises spending + investment over saving or hoarding cash
What are 2 risks of negative interest rates?
- Lowers bank profitability: erodes interest rate income of banks
- Can cause banks to take excessive risks in search of higher returns
What are negative interest rates?
When central bank lowers the nominal interest rate below zero so interest is paid to borrowers rather than to lenders
Name 2 advantages of monetary policy
- Targeting interest rate controls inflation
- Easy to implement
Name 3 disadvantages of monetary policy
- Effects have a time lag
- Ability to reduce inflation depends on type (effective on demand-pull)
- Risk of hyperinflation
How does quantitative easing affect interest rates?
Lowers interest rates in order to encourage borrowing
How does quantitative easing affect exchange rates?
When interest rates fall, investors switch money from Uk assets to others. There is a fall in demand for the pound but a rise in supply. Therefore price falls against other currencies
What is fiscal policy?
The use of government spending, taxation and borrowing to boost AD (and meet its macroeconomic objectives)
What is expansionary fiscal policy?
Involves an increase in government spending and lowering taxes to boost AD
What is contractionary fiscal policy?
Involves a decrease in government spending and raising taxes to lower AD
What is a drawback of expansionary fiscal policy?
Leads to a worsening of government budget deficit, and may mean government have to borrow more to finance this
What is the difference between a budget deficit and budget surplus?
Budget deficit - when expenditure exceeds tax receipts in a financial year
Budget surplus - when tax receipts/income exceed expenditure
What are 3 limitations of fiscal policy?
- Governments may have imperfect information about the economy, leading to inefficient spending
- Time lag: could take months or years to have an effect
- If government spends too much, could be difficulties paying back and borrowing in the future
What are 2 sources of government revenue?
- Direct taxation: taxation on income, wealth and profit e.g income tax
- Indirect taxation: taxation on spending by consumers on goods and services e.g VAT
What is government debt?
The total amount of money the British government owes to the private sector and other purchasers of UK gilts e.g Bank of England
What are automatic stabilisers?
Automatic fiscal changes in the economy as it moves through different stages of the business cycle without direct intervention from government e.g increase in welfare benefits when unemployment rises
What is discretionary fiscal policy?
Intentional government changes in tax rates and government spending to achieve macroeconomic objectives
What is crowding out and give an explanation
The negative impact that government spending can have on private investment
Government borrowing to finance spending reduces the availability of credit in the private sector due to competition within the economy, raising interest rates (due to greater demand which increases the cost of borrowing of private firms) and reducing private investment
What are 2 benefits of fiscal policy?
- Can promote strong and sustainable growth
- Effective in deep recession (direct, not reliant on confidence)
What impacts the effect of fiscal policy?
- Crowding out
- The size of the multiplier
- Political willingness/ability to borrow
What are 2 examples of automatic stabilisers?
- A fall in tax revenues during a recession
- Increase in state welfare benefits when unemployment is rising
What are the 3 types of tax?
- Progressive: when the average rate of tax rises as incomes increase
- Regressive: a tax which takes a higher rate of tax from low incomes
- Proportional: a tax with a fixed rate for all taxpayers, regardless of income
What are supply side policies?
A set of economic measures/strategies that aim to increase the ability of an economy to produce goods and services, improving long-run productive capacity and efficiency (LRAS)
What is the difference between market-based and interventionist policies?
Market-based - limit the intervention of government and allow the free market to eliminate imbalances
Interventionist - rely on government intervening in markets
What are 3 aims of market-based supply side policies?
- To increase incentives: reducing income and corporation tax to encourage spending/investment
- To promote competition: by deregulation or privatisation there is more competitiveness, increasing economic efficiency
- To reform the labour market: reducing minimum wage and trade unions, increases mobility of labour, more efficient market
What are 4 aims of interventionist supply side policies?
- To promote competition: stricter competition policy could reduce monopolies
- To reform the labour market: can improve geographical immobility by subsidising relocation of workers
- To improve skills and quality of labour market: government can subsidise training/education, more spending on health improves quality of labour force
- To improve infrastructure
What are 3 aims of supply side policies?
- To improve incentives to work and invest in skills (human capital)
- To increase labour/capital productivity
- To increase capital investment
What are 3 weaknesses of supply side policies?
- Market based policies e.g cutting tax could widen inequality
- Can impact government budget (tax cuts means government earns less)
- Can create negative externalities e.g environmental degregation (pollution, deforestation)
What are 2 strengths of supply side policies?
- Only policies that tackle structural unemployment: directly improve education and training
- Improved productivity, efficiency and economic growth
How does cutting tax (e.g income, corporation) affect LRAS?
- When taxes are cut, consumers earn more disposable income and firms retain more profit
- This results in consumers being more motivated to work harder, increasing productivity
- This results in firms increasing capital investment and producing more goods/services
- Overall, shifting LRAS outwards
How does deregulation affect LRAS? (supply side policies)
- When there is a removal of government controls, it becomes cheaper for firms to produce a good
- This results in a reduction of production costs, allowing firms to retain more profit
- This encourages firms to invest in capital, increasing productivity and therefore LRAS
How does privatisation affect LRAS? (supply side polcies)
-This means that firms move out of the public sector and into the private sector
- Firms are profit maximisers, so there is incentive to innovate and become efficient
- This increases the supply ogf goods/services and LRAS shifts outwards
What are the 2 categories of supply-side policies?
- Market-based supply side policies
- Interventionist supply side policies
What are market-based supply side policies and 3 examples?
The removal of barriers which prevent the efficient work of free markets, increasing competitiveness
e.g privatisation, deregulation, lowering tax
What are interventionist supply side policies and 2 examples?
Involves government intervention to boost the economy and overcome market failure
e.g government spending on human capital (training and education), direct subsidies
What are 2 limitations of monetary policy?
- Liquidity Trap: when a cut in interest rates fails near 0 to stimulate economic activity. People and businesses prefer to hoard cash rather than invest or spend = MP is ineffective
- Changing interest rates affect exchange rate: contractionary monetary policy causes an appreciation in the exchange rate (high interest rates attract foreign capital seeking better returns), makes exports less competitive
Global financial crisis
- Decline in world GDP in 2008 - 2009
- Risky bank loans and mortgages, especially in the US
- Banks had lost huge funds, and required assistance from the government in the form of bailouts
What are the 5 macroeconomic objectives?
- Economic growth
- Low/stable rate of inflation
- Low unemployment
- Equilibrium in balance of payments
- Lower income inequality
- Balanced government budget
What is the role of the bank of England in monetary policy?
- Monetary Policy Committee meet once a month to set the monetary policy (9 members)
- They set the Bank Rate and discuss if quantitative easing is required
What are the 2 demand-side policies?
- Monetary policy
- Fiscal policy
1 fiscal and monetary responses to the Great Depression USA (1929-1930s)
- Roosevelt’s New Deal (1933-1939): government spending on infrastructure/conservation projects
- In the late 1930’s raised the bank rate: strengthen the exchange rate (following cuts in 1930 from 6% to 4%)
1 fiscal and monetary responses to the Great Depression UK (1929-1930s)
- 10% tariff on all imports (except from British Colonies): to promote domestic production/consumption
- The Bank Rate was lowered from 6% to 2% in late 1931
1 fiscal and monetary responses to the Financial Crisis USA (2008)
- ‘Economic Stimulus Act of 2008’ injected $152bn. in fiscal stimulus (increased AD)
- Federal Reserve cut bank rates eight times (2007-2008) from 5.25% to 0.25%
1 fiscal and monetary responses to the Financial Crisis UK (2008)
- income tax cuts, VAT reduction of 2.5%, £20bn. small business loan guarantee scheme
- Bank of England cut the Bank Rate nine times (2007-2009) from 5.75% to 0.5%
