AS Unit 5: Government Macroeconomic Intervention

Question 1

Price stability

Answer 1

Low and stable inflation rate. Would not be 0 because:
-any measure of inflation tends to overstate any rise in prices
-to aim for 0 may result in deflation
-low and stable rises in prices caused by higher spending may encourage firms output
An increasing number of governments are setting inflation targets for central banks. May reduce inflationary expectations. If firms, workers and households have confidence in a central banks ability to meet its target, they may act in a way that doesn’t push up prices

Question 2

Low unemployment

Answer 2

Having a low proportion of the labour force unemployed has advantages like high output, high tax revenue and low spending on unemployment benefits. Governments try to ensure that any unemployment is sgort term so workers don’t lose skills and habits. They promote labour mobility. The government is also concerned with the quality of unemployment. This is because the effect of low unemployment on the economy and the workers may not be beneficial if the jobs are unskilled, insecure and low paid

Question 3

Economic growth

Answer 3

Governments don’t want negative or too slow economic growth. If output is falling, unemployment may rise and living standards may decline. Governments also want to avoid high economic growth because an economy could overheat with AD rising faster than AS. Pressure could be put on resources and inflationary pressure may build. Entrepreneurs may be overoptimistic and set up firms that don’t have a long term future. Households may expect incomes to continue to increase at a high rate encouraging them to take out loans they may struggle to repay. For growth rate the government takes into account that size of the labour force, changes in productivity and advances in technology

Question 4

Fiscal policy and the budget

Answer 4

Is the use of taxation and government spending to manage AD for macroeconomic aims. The annual budget is a statement of fiscal policy. A surplus arises when tax revenue exceeds government spending, a deficit is the opposite and balance is equal
Most governments aim for balance over time but may aim for a deficit in the short term. A deficit may occur as a result of deliberate government action and automatic stabilisers. If there is a decline in economic growth and a rise in unemployment, a government may cut taxes and increase spending. Spending on benefits will rise and tax revenue will fall. A budget deficit occurs due to a fall in activity (cyclical deficit). Governments are concerned with structural deficits which arise when a government is committed to too much spending relative to revenue. Deficit doesn’t disappear when GDP increases. In reality a deficit may contain both elements. A deficit will decline if there is a rise in revenue and/or a fall in spending but a rise in spending and/or a cut in taxes could reduce a deficit since these could increase activity

Question 5

The national debt

Answer 5

Expressed as a percentage of GDP. Government of public sector debt is the total debt of a central government or public sector. Connected to budget deficits and surpluses. If there is a deficit in 1 year, it will add to national debt but extra revenue from a surplus may pay off part of the debt. Increases during economic downturns since spending rises faster than tax revenue. May be a tendency during booms to spend more (structural deficit). Conflict can increase national debt. There is an opportunity cost of interest payments. Large national debt may make financial institutions, firms, individuals and other governments reluctant to lend, due to debts about their ability to pay interest and repay. Borrowing a large amount may increase interest rates. Not the same as external debt since some is owed to the citizens. National debt to GDP ratio is reduced if there is some repayment or if GDP rises

Question 6

Indirect taxes

Answer 6

Taxes on the sale of goods and services. Largely paid by customers but are collected by firms. The firms are legally responsible to pay them to the government. They try to pass on as much to consumers as possible. The more inelastic, the more is passed on. Specific indirect taxes have a set amount of tax. Indirect taxes on particular products are exise duties (or sin taxes which are mainly used to discourage people buying those bad for health)

Question 7

Direct taxes

Answer 7

Taxes on income and wealth

Question 8

Indirect vs direct taxes

Answer 8

Governments rely more in indirect since they can be changed quickly and easily. They are cheaper to collect than direct and discourage the purchase of goods. Indirect don’t discourage effort, innovation and saving. Higher direct taxes may put people off joining the workforce, working overtime and cut their hours since disposable income is reduced. Direct may be a disincentive to save since income is taxed twice. May stop firms introducing new methods/products if post-tax is low. Some workers may decide to work more hours to maintain disposable income or can lead to tax avoidance and tax evasion. Greater reliance on indirect taxes may less evenly distribute income since regressive. They can also be inflationary since there are extra costs on suppliers. People may expect prices to continue to rise. People may smuggle products to avoid indirect taxes

Question 9

Progressive, regressive and proportional taxes

Answer 9

Indirect are regressive and direct are usually progressive. Progressive takes a higher percentage as income rises. Regressive taxes a smaller percentage as income rises. Proportional is fixed and doesn’t change as income changes

Question 10

Marginal and average rates of taxation

Answer 10

The mrt is the proportion of extra income taken in tax. The art is the proportion of total income taken in tax. With a progressive tax, mrt is higher than art. The proportion paid on extra income is greater than the proportion they pay on the total amount earned. With a regressive tax, mrt is lower than art. With a proportional tax mrt equals art

Question 11

Reasons for taxation

Answer 11

Raise revenue to finance government spending. Influence AD. In theory a government could finance this just by printing more money but would be very inflationary. The government needs to reduce public sector demand to free up resources. Progressive may be used to distribute income more evenly. Narrows the income gap which could be further narrowed by the government using tax revenue from the ruck for benefits for the poor. Discourage some consumption. May be imports

Question 12

What does government spending include

Answer 12

Spending on transfer payments
Current spending
Capital spending

Question 13

Spending on transfer payments

Answer 13

Includes unemployment benefits, state pensions and interest payments on national debt

Question 14

Current spending

Answer 14

Is on goods and services to provide state financed services. Covers opportunity costs

Question 15

Capital spending

Answer 15

Is on goods used in the public sector

Question 16

Exhaustive spending

Answer 16

Covers current and capital spending. It uses resources and is counted in AD and GDP

Question 17

Non-exhaustive spending

Answer 17

Is on transfer payments. Does not involve the government deciding how resources are used. The people who receive the payments make the decision

Question 18

Reasons for government spending

Answer 18

Spend to influence AD and so the level of economic activity. If private sector spending is too low, a government may inject more spending. Will aim for a deficit. May spend to increase AS so can raise an economy’s productive potential. Spending on transfer payments ensures people have a basic income level so avoid poverty and reduce inequality. Governments also spend on merit and public goods to overcome market failure. As GDP rises the government us under pressure to spend more on these since people have higher expectations. Advances in technology make it possible to do more complex operations that require more expensive aftercare. Governments may spend to win political popularity so rises before an election or by different groups

Question 19

Expansionary and contractionary fiscal policy

Answer 19

Expansionary to increase AD. Achieved by an increase in government spending and/or cutting taxes. The government may increase an existing deficit to make a larger net injection.
Contractionary to reduce AD growth. Government will reduce spending and/or increase taxes and aim for a surplus.
Changes in spending may be the result of policy changes or economic activity changes. Deliberate change in government spending and taxation is discretionary fiscal policy

Question 20

Automatic stabilisers

Answer 20

Forms of government spending and taxation that change without deliberate government action to offset fluctuations in GDP. In a recession, spending on unemployment benefits rises. Tax revenue from taxes falls

Question 21

Impact of contractionary fiscal policy on the macroeconomy

Answer 21

May be used to reduce demand-pull inflation. Income taxes may rise, threshold to start paying taxes falls and tax base is widened. Government cutting their own spending is better in places where only a small proportion of the population pays income tax. Higher taxes and lower spending may reduce AD or its growth. Raising income tax to reduce demand-pull inflation may not go as planned since workers may seek higher wages to maintain disposable income. Costs of production rise. Generates cost-push inflation. Higher income taxes mat also be a disincentive as workers may leave the workforce or emigrate, reducing productive capacity and AS

Question 22

Impact of expansionary fiscal policy on the macroeconomy

Answer 22

May be used to increase output and rise employment. If there is high cyclical unemployment, the government will try to rise AD. his may be done by cutting direct and indirect taxes to stimulate consumer spending an investment. COuld add to AD by increase own spending. May not be effective if households and firms are worried about the future. They may save most of any extra disposable income as a result of lower taxes and higher spending. Government may inject too much spending causing demand-pull inflation

Question 23

Monetary policy

Answer 23

Any policy that affects the price or quantity of money. It seeks to influence AD. The tools are usually applied by the central bank of the country or area

Question 24

Interest rates as a tool of monetary policy

Answer 24

The interest rate is the cost of money. Households and firms who want to borrow money have to pay interest. Households and firms who lend money are paid interest. Changes in interest rates is mainly used to achieve price stability

Question 25

Money supply as a tool of monetary policy

Answer 25

Changes in the quantity of money can influence AD. The main cause is lending by commercial banks. Therefore central banks try to influence lending by commercial banks

Question 26

Exchange rates as a tool of monetary policy

Answer 26

Central banks may manipulate the exchange rate to raise or lower AD

Question 27

Credit regulations as a tool of monetary policy

Answer 27

Central banks may impose credit regulations on commercial banks to help maintain financial stability and to influence lending. Most central banks require commercial banks to hold a proportion of their assets in a form that can be quickly soil and so converted into cash. This is to ensure the commercial banks can meet their customers likely demand for cash even in a financial crisis

Question 28

Expansionary monetary policy

Answer 28

May be used to increase AD. A cut in the interest rate, an increase in the money supply and a reduction in restrictions on bank lending can achieve an increase

Question 29

Contractionary monetary policy

Answer 29

May be used to reduce AD. This might include a rise in the interest rate, a decrease in the money supply and restrictions on bank lending

Question 30

How do central banks use monetary policy to achieve a price level?

Answer 30

Many central banks are given a target inflation rate and told to use interest rates to achieve it. If inflation is rising out its target, interest rates will be raised to reduce AD. May reduce demand-pull inflation because the cost of borrowing will rise, discouraging large purchases and savings may be increased as the return will rise

Question 31

Monetarists view on monetary policy and the price level

Answer 31

Monetarists argue that the only way to reduce inflationary pressure is to lower the growth of money supply. If increases in money supply do not exceed output increases there will not be price rises.

Question 32

A rise in interest rate affect on spending

Answer 32

A rise in interest rate may not discourage spending. Commercial banks usually keep rates in line with that of the central banks as this is what they pay the central bank if they have to borrow. Even if consumers are faced with higher interest rates they may not reduce spending if optimistic about the future

Question 33

Interest rates affect on investment

Answer 33

A rise in interest rates may have an adverse effect on investment because it will decrease the cost of borrowing to invest and will increase the opportunity cost of using profits to invest. Capital stock will decline if investment falls below depreciation. The resulting decrease in AS can push up the price level

Question 34

Interest rates compared to other countries

Answer 34

Central banks may be worried that if interest rates are higher than other countries, they may attract an inflow of money increasing the exchange rate. Members of a union may operate the same rates and the areas central bank will make interest and exchange rate decisions

Question 35

Monetary policy to correct deflation

Answer 35

A government will not seek to stop good deflation but correct bad deflation. Can reverse a fall in AD with expansionary monetary policy but a decrease in interest rates and/or and increase in money supply may not work because firms and households may not be pessimistic in deflation so won’t spend more even if there is more money in circulation and it is cheaper to borrow

Question 36

Monetary policy and the price level

Answer 36

When interest rates are low it may not be possible to reduce them much further and any cuts may have little effect. Central banks may increase the money supply, increasing the funds for commercial banks to lend. Banks may be reluctant to lend because they may think there is an absence of creditworthy borrowers

Question 37

Monetary policy and equilibrium national income

Answer 37

If there is spare capacity, expansionary monetary policy may result in higher national income. A cut in interest rates or an increase in money supply may encourage consumer spending and investment. The higher AD can increase real output

Question 38

Monetary policy and real output

Answer 38

Higher output causes an increase in employment

Question 39

Monetary policy and employment

Answer 39

Contractionary monetary policy may reduce national income, output and employment but if it is used when the economy is operating with all resources employed, it may reduce inflation

Question 40

Controlling the money supply as effectiveness of monetary policy

Answer 40

Can be hard to control the money supply because commercial banks have a strong incentive to increase lending and ,ay seek to get round any limits a central banks puts on the growth of their lending. Trying to control certain forms of money may lead to new forms being used

Question 41

Time lag as effectiveness of monetary policy

Answer 41

There is a time lag between changing interest rates and the full effect being transmitted to the macroeconomy but this is less than some fiscal policy measures

Question 42

Uncertainty as effectiveness of monetary policy

Answer 42

Interest rates are uncertain. Some households and firms are more likely than other to cope with interest changes. A rise harms borrowers and benefits savers. A high interest rate may also have an adverse effect on unemployment and economic growth as with a deflationary fiscal policy measure

Question 43

Mobility as effectiveness of monetary policy

Answer 43

With increasing mobility of financial investment, it can be ard for a country to operate an interest rate that is significantly different from rural countries

Question 44

Supply side policy objectives

Answer 44

Used to increase AS by improving the workings of product and factor markets. Sometimes the tools will reduce government intervention or at other times will increase. Tools seek to increase productive capacity and shift LRAS to the right, mainly by increasing productivity

Question 45

Supply-side policy toolds

Answer 45

Tools include spending on education and training, promoting infrastructure development and support for technological improvement. Others include cuts in corporate tax, cuts in income tax, trade union reform, privatisation, deregulation and relaxation of immigration control

Question 46

Education and training

Answer 46

Spending will increase the quality so workers skills and productivity may increase as well as their flexibility and mobility. A more efficient labour force is a key cause of an increase in productive capacity. A better educated and trained population can also increase the quality of entrepreneurship which can increase innovation

Question 47

Promoting infrastructure development

Answer 47

Good quality infrastructure keeps the costs of firms low and enables them to get their products to the market quickly. The government may finance and provide transport infrastructure itself or encourage the private sector to provide

Question 48

Support for technological employment

Answer 48

Can enable capital equipment to produce a greater output at a lower cost. A government can subsidise the development and introduction of new technologies

Question 49

Other supply tools

Answer 49

Cuts in corporate tax encourages investment as firms have more funds to invest and they know they can keep more profit. More investment increases AD and AS. Cuts in income tax encourages workers to increase working hours and accept promotion and greater responsibility. May also persuade some to join or stay in labour force. Trade union reform may increase flexibility and mobility and cut says lost through strikes. Make make MNCs more willing to invest raising productivity and production. Privatisation and deregulation because firms may be more efficient in the private sector. Removing barriers to entry, rules and regulation can lower costs of production. Encouragement of immigration of skilled workers can increase quality and quantity of labour

Question 50

The impact of supply-side policy tools on national income and real output

Answer 50

By increasing the productivity of labour and capital, national income and real output can increase. This is done by increasing the quality and quantity of resources. Government spending on infrastructure will increase the quantity of resources for the production and transport of products. Technological improvement raises the quality and productivity of capital

Question 51

The impact of supply-side policy tools on the price level

Answer 51

Over time AD tends to increase. If increases in AS keep up with higher AD a country can enjoy higher real GDP without experiencing demand-pull inflation. Governments may also use supply-side policy tools to correct cost-push inflation

Question 52

The impact of supply-side policy tools on employment

Answer 52

Improved education and training will increase skills and geographical and occupational mobility. This should reduce frictional and structural unemployment. Technological improvement may result in some workers being replaced by capital. Technological improvement and infrastructure development may increase employment because both lower costs of production which increase sales. More workers taken on to produce higher output

Question 53

The effectiveness of education and training and supply-side policy

Answer 53

Spending on education and training can be effective in the long run because it may directly increase the quality of labour and productive capacity. Less effective in the short run as it takes time to have an effect. In the short run may also contribute to inflation since higher government spending may increase AD before AS. More education and training may not be effective if not of a high quality or develops skills not in demand long term. May be successful in raising skills or workers but if pay rises more than productivity, costs of production still rise

Question 54

The effectiveness of infrastructure development as supply-side policy

Answer 54

Infrastructure development can be expensive and take time. Transport infrastructure development may not always be well linked. May also have harmful effects on the environment

Question 55

The effectiveness of technological improvement as supply-side policy

Answer 55

The overall benefit is beneficial but benefits are not always evenly spread and harmful to some. It involves change. New products and methods of production are created. New jobs appear and others are lost. Some may have to change jobs and move to different areas

Question 56

The effectiveness of supply side policy tools

Answer 56

Any tool which increases AS may not rise output if initially operating at spare capacity. This is because while productive potential will increase, it will not be used if there is not enough AD. Firms are capable of producing more but won’t if it won’t sell