4.5.4 Macroeconomic policies in a global context

Question 1

What is fiscal austerity?

Answer 1

Fiscal austerity is the term used to describe policies designed to reduce the size of a government fiscal deficit and
eventually control / lower the size of the outstanding national debt. In the UK, austerity policies have been in place
since 2010 in the aftermath of the Global Financial Crisis. Austerity has also been imposed in countries such as Greece
and Italy as part of the bail-outs of national governments by the European Union and the International Monetary Fund

Question 2

What are policies to reduce a fiscal deficit?

Answer 2

• Cuts in govt spending
• Higher taxes
• Supply side policies to encourage growth

Question 3

Give examples of how the government can cut down on spending

Answer 3

• Controlling public sector pay including wage freezes or limiting annual pay awards to 1%
• Limiting welfare entitlement
• Privatisation of state assets so that a government no longer has to cover losses
• Reductions in the size and scale of government subsidies

Question 4

Give examples of how the government can increase taxes

Answer 4

• Higher indirect taxes such as VAT rising to 20%
• Cutting tax allowances or ending certain tax reliefs
• Bringing in new taxes e.g. new environmental taxes or taxes on digital businesses

Question 5

Give examples of how the government can implement supply side policies to encourage growth

Answer 5

• This approach focuses on the argument that a growing and a more competitive economy will be a more
  effective way of cutting the deficit and the debt in the long-term
• Stronger GDP growth increases tax revenues because the tax base widens, and people/businesses are earning
  higher incomes and profits
• In a progressive tax system, expanding incomes and perhaps higher prices will lead to a faster growth of tax
  receipt
• Growth cuts a deficit as a % of GDP because the denominator (GDP) has increased

Question 6

Explain arguments in favour of fiscal austerity

Answer 6

1. Reducing the budget deficit and the national debt is in the long run interests of economy – for example it
   helps to keep UK taxes lower and can avoid the problem of the state sector crowding-out investment and
   growth in the private sector
2. Shrinking state encourages private sector growth in the long-run
3. There is a high opportunity cost from over £50 billion spent each year on debt interest
4. Cutting the fiscal deficit can improve investor confidence and might attract more FDI into the UK
5. The upturn of the economic cycle is time for government to borrow less – ahead of another downturn or
   recession – it makes sense to be running stronger budget finances before the economy enters a cyclical
   slowdown or downturn

Question 7

Explain arguments against fiscal austerity

Answer 7

1. Austerity is self-defeating especially if it leads to price deflation and lower employment, because this depresses
   employment and investment which are vital to sustain tax revenues in the future
2. Government bond yields are low – the yield on ten-year government bonds is less than 2 per cent – so this
   is an opportune a time to invest more because infrastructure investment will increase both AD and LRAS
3. Wrong to cut state spending when economy is in a liquidity trap (i.e. unresponsive to low interest rates)
4. Economic growth is needed to pay back the debt and fiscal austerity makes this harder to achieve
5. There are damaging social consequences from fiscal austerity – it risks increasing inequalities of income and
   can be a factor in more families having to use food banks and borrowing at very high interest rates from
   payday lenders
6. Pay freezes in the public sector have harmed recruitment and led to growing shortages of key workers in
   education and healthcare. This leads to longer waiting times and threatens the delivery of important merit
   goods

Question 8

How do the Keynesians view fiscal policy?

Answer 8

Keynesian economists tend to favour the active use of fiscal policy as the may way of managing demand and economic
activity. They argue that the fiscal multiplier effects of increased government spending can be high, and that fiscal
policy is a powerful device for helping to stabilise confidence, demand, output and jobs especially after severe external
economic shocks.

Question 9

Explain how counter cyclical policies, targeted tax changes, government capital spending and government borrowing will help the economy

Answer 9

Question 10

How can welfare systems reduce inequality of income and wealth?

Answer 10

• Direct cash transfers to poorer households – conditional cash transfers link cash benefits to households
  dependent on certain actions e.g. having their children immunised or attending school regularly
• Measures to introduce a basic pensions system – which in theory would allow households to save more of
  their disposable income or increase spending on necessities such as education or better health care
• Government subsidies for transport and child care to increase labour market participation

Question 11

How can labour market policies reduce inequality of income and wealth?

Answer 11

• Employment protection including legal protections for workers wanting to be represented by a trade union
• Minimum wage laws - offering a guaranteed pay floor for lower-paid workers
• Trials to introduce a universal basic income
• Incentives to improve business training / productivity which ultimately will increase productivity. Productivity
  is the biggest single driver of improved wages over time

Question 12

How can tax reforms reduce inequality of income and wealth?

Answer 12

• Progressive taxes on the income / wealth of the rich
• Taxing profits of businesses to fund state spending including measures to curb tax avoidance by transnational
  corporations

Question 13

How can goverments improve the functions of labour markets to improve international competitiveness?

Answer 13

o Investment in all levels of education and training including early years education and
technical/vocational courses for school and college leavers
o Encouraging inward migration of skilled workers – some nations have chosen a points-based system
of immigration targeting skilled occupations where there are labour shortages
o Improvements in management quality

Question 14

How can goverments invest in critical infrastructure to improve international competitiveness?

Answer 14

o Better motorways, ports, hi-speed rail, new sewers – infrastructure gaps can severely hamper
businesses
o Investment in clean energy networks to help support sustainable growth
o Communications e.g. super-fast broadband, 4G and 5G networks

Question 15

How can goverments support enterprise to improve international competitiveness?

Answer 15

o Improved access to business finance e.g. for start-ups and small & medium-sized enterprises
o Incentives for business innovation and invention including lower taxation on profits from patented
products
o Reductions in business red tape

Question 16

How can goverments improve macroeconomic stability to improve international competitiveness?

Answer 16

o Maintaining low inflation / price stability to help confidence
o A sustainable and more competitive banking system to improve the flow of finance for investment
o A competitive exchange rate versus major trading partners – for some countries this has involved
moving towards managed floating exchange rates and/or a competitive devaluation of a fixed
exchange rate

Question 17

What are external shocks?

Answer 17

Shocks are unexpected changes in the economy that can affect variables such as inflation and the growth rate of GDP.
In an inter-connected global economy, events in one part of the world can quickly affect many other countries.

Question 18

What is an example of an external shock?

Answer 18

For example, the global financial crisis (GFC) brought about recession in many countries and financial distress in many
regions. It also led to a fall in FDI flows into poorer countries and increased pressure on governments in rich nations
to cut overseas aid budgets.

Question 19

Give examples of demand side shocks

Answer 19

• Economic downturn / recession in a major trading partner
• Unexpected tax increases or cuts to government spending programmes
• Financial crisis causing bank lending /credit to fall and which spreads to more than one country/region
• Unexpected changes in monetary policy interest rates
• Significant job losses announced in a major industry

Question 20

Give examples of supply side shocks

Answer 20

• Steep rise/fall in oil and gas prices or other commodities traded in the world economy
• Political turmoil / strikes
• Natural disasters causing a sharp fall in production and damage to infrastructure
• Unexpected breakthroughs in production technologies which can lead to unexpected gains in productivity
• Significant changes in levels of labour migration into/out of a country

Question 21

When analysing the impact of an external shock, what things do I have to consider the likely impact on?

Answer 21

• Real GDP growth
• Inflation (demand-pull and cost-push)
• Unemployment
• Competitiveness
• The Trade Balance
• Government finances
• Possible impact on inequality

Question 22

Evaluate what the responsiveness of a country to an economic shock depends on

Answer 22

1. Floating exchange rates (i.e. is there scope for a depreciation?)
2. Freedom to set / adjust monetary policy when conditions change - does the central bank have autonomy to
   change interest rates or bring in unconventional policies such as QE?
3. Geographically and occupationally mobile / flexible labour force - a more flexible labour force helps an
   economy adjust to shocks that change the pattern of exports
4. Strong non-price competitiveness of domestic businesses - this helps make demand and output more resilient
   to fluctuations in the global economy
5. A diversified economy that is not over reliant on a few sectors
6. Strong fiscal position (stabilisation funds) - e.g. strong finances give a government the scope to run a fiscal
   stimulus when aggregate demand falls

Question 23

Explain the Keynesian approach to external economic shocks

Answer 23

• Keynesians believe that free markets are volatile and not self-correcting in the event of an external shock
• The free-market system is prone to lengthy periods of recession & depression
• Economies can remain stuck in an “underemployment” equilibrium
• In a world of stagnation or depression, direct state intervention may be essential to restore confidence and
  lift demand.
• Keynes was one of the first economists to criticise the economics profession for adhering to unrealistic
  assumptions

Question 24

What are transnationals?

Answer 24

Large businesses that operate in a number of countries. They often separate their
production between various locations or have their different divisions – Head Office and Administration, Research and
Development, Production, Assembly, Sales – separated around a continent or the globe.

Question 25

What are reforms to reduce corporate tax avoidance?

Answer 25

1. Some governments want to introduce a standard minimum tax rate on corporate profits across all of the
   advanced countries.
2. Others favour introducing new digital services taxes specifically for businesses such as Amazon, Apple,
   Facebook and Google.

Question 26

What is transfer pricing?

Answer 26

Transfer pricing is also known as profit shifting and it happens when a TNC moves the profits they have made from
subsidiaries in a high tax country to other subsidiaries in a lower tax nation. Usually this happens when a TNC sets up
an internal trade - for example a royalty for using a trademark or a charge for using component parts which then
affects the costs of each subsidy and helps to ensure that lower profits are booked in the higher-tax economy.

Question 27

What are potential benefits of TNCs for host countries?

Answer 27

1. Provision of significant employment and training to the labour force in the host country
2. Transfer of skills and expertise, helping to develop the quality of the host labour force
3. TNCs add to the host country GDP through their spending, for example with local suppliers and through
   capital investment
4. Competition from MNCs acts as an incentive to domestic firms in the host country to improve their
   competitiveness, perhaps by raising quality and/or efficiency
5. TNCs extend consumer and business choice in the host country
6. Profitable MNCs are a source of significant tax revenues for the host economy (for example on profits earned
   as well as payroll and sales-related taxes)

Question 28

What are potential drawbacks of TNCs for host countries?

Answer 28

1. Domestic businesses may not be able to compete with MNCs and some will fail
2. TNCs may not feel that they need to meet the host country expectations for acting ethically and/or in a
   socially-responsible way
3. TNCs may be accused of imposing their culture on the host country, perhaps at the expense of the richness
   of local culture.
4. Profits earned by TNCs may be remitted back to the TNC’s base country o low tax haven rather than reinvested
   in the host economy.
5. TNCs may make use of transfer pricing and other tax avoidance measures to significantly reduce the profits
   on which they pay tax to the government in the host country