Chapter 3 - Macro Policy Flashcards
What is fiscal policy?
Changes in Gov.Spending and taxation to influence AD in an economy
What are the two types of fiscal policy?
Expansionary = Increase AD
Contractionary = Decrease AD
What diagram do we use when talking about fiscal policy?
Keyensian LRAS with AD shifts left or right
What are the 5 different expansionary fiscal policies the Gov could implement? (opposite for contractionary)
1) Reduce marginal rate of income tax for those in lower income tax brackets or increase the income tax free allowance
2) Reduce marginal rate of income tax of rich (highest income tax bands)
3) Reduce level of regressive taxes.
Poor have high marginal propsensity to consume
4) Reduce level of cooporation tax
5) Boost their spending in economy, boosting G. Also multiplier effect increasing incomes and further faciliting rounds of spending
What are the benefits of expansionary fiscal policy? 4
1) Increases in growth. Greater demand -> increased output exhuasting spare capacity -> increase in real GDP -> increase in economic growth
2) Decrease in unemployment -> Labour derived demand
3) Certain types of Gov spending and tax cuts can be quick to impact the economy such as VAT
4) Increases in LRAS
Do any of the expansionary fiscal policies affect LRAS?
1) Reducing cooporation tax = INcrease retained profits for businesses -> easier to finance investment -> increase marginal propensity to invest -> improving quantity and quality of capital stock in economy -> increasing LRAS
2) Gov spending on infrastructure -> education and healthcare improve productivity -> public infrastructure imporves efficiency, improvin quality, lowering costs of production for firms
What are the cons of expansionary fiscal policy? 6
The cons of running a budget deficit, where Gov spending exceeds tax revenue
1) Increased inflation
2) Deterioration of Gov finances
Funding expansionary fiscal policies may mean tax rises in future -> if indirect, regressive the poor suffer -> worsening income inequality -> going agaisnt major macroeconomic objective -> cutting spending problems
3) Ricardian Equivalance problem
If further tax increases are ANTICIPATED -> consumers save gains in disposable income from current tax cuts INSTEAD OF SPENDING -> reducing increases in AD and gains from expansionary fiscal policy
4) If deterioration of Gov finances is severe Where budget deficits and national debts rise to unsustainable levels -> confidance can be lost in the state of the government.
Leads to mass selling of Gov bonds -> lower demand for new issues -> driving up interest rates on Gov debt -> potentially bankrupting Government forcing bailout.
COUNTER TO THIS = increase in AD -> increases in growth -> higher incomes and profits overtime -> increased fiscal intake for Gov in the long run -> paying off colected debts
5) Crowding out of private sector
Where excess government borrowing increases demand for loanable funds in loanable funds market -> pushing up equilibrium interest rates -> more expensive for firms to finance their investments -> reduce investment in economy -> harming SR and LR economic growth
6) Time lags
Some forms of gov spending take a while for the benefits to filter throuigh to the economy, I.E building schools
What are the pros of contractionary fiscal policy? 4 AKA Austeristy policy
Pros of a budget surplus
1) Lower gov borrowing and debt
Cuts to gov spending + increases in taxation = improved gov finances and reduced need for borrowing and more money to service debts -> improving budegt deficit and national debt -> greater confidence in state of government finances -> increasing demand for gov bonds -> reducing interest rates on gov bonds -> easier and chepaer for gov to raise finance over time -> ALSO stabel gov finances attract FDI
2) Flexibiity for gov spending when necessary
Much less unproductive spending on servicing debt interest -> room for expansionary fiscal policy when needed in a recession -> room for spending on public services or infrastructure
3) Less crowding out of private sector
Gov dont need to borrow excessively -> reducing demand for loanable funds in loanable funds market -> reducing equilibrium interest rates -> cheaper for firms to finance investment
4) Can keep inflation low
Decreases in AD through decreases in G and C and I -> decrease in output -> decrease in pressure on exisiting factors of production -> reduced demand pull inflation
What are the cons of contractionary fiscal policy? 3 AKA austerity policy
1) Potential shock to economy
AD falls -> growth decreases -> unemployment increases -> potential recession.
Therefore if economy is fragile then gov need to be very careful with contractionary fiscal policies to avoid major macro ecnomiv objective conflicts
2) Widening income inequalities
Regressive taxes like VAT burden poor more, same with cutting spending on infra. -> long term gov finances could actually worsen if spending is needed to implemetn policies to overcome income inequality AND to deal with costs of income inequality
3) Distorting incentives
If income tax, cooporation tax and/or VAT are raised -? discouraging work and entrepreneurial spirit -> cooporation tax increases discourages investment and FDI -> long run economic growth rates will suffer
What are the evaluation points for expansionary / contractionary fiscal policy? 7
I.E What factors should be considered when implementing said policies
1) Initial level of economic activity
If large negative output gap (large level of spare capacity) = Increase in AD will lead to larger increase in output and decrease in unemployment, cuz w spare capacity it is easy for firms to expand production by using up excess unemployed labour and capital.
ALSO the lack of pressure will limit inflation
If low levels of spare capacity = Difficult for firms to find new workers and increase output, low increases in output and employment and large increase in inflation
2) Level of consumer and business confidence
If low = a reduction in tax, regardless of how big, may have little impact on stimulating AD as consumer worry asbout their future employment prosepects, reducing MPC. Same with businesses concerned about lower profits
3) State of government finances
If gov is in strong financial position ; i.e a budget surplus, then financing expansionary policy will not be such a burden. Less oppportunity cost argument and burden on future generations.
OPPOSITE IS TRUE if large budget deficit
4) Keynesians argue that infrastructure spending can CROWD IN the private sector
Gov spends and boosts demand in economy -> economic activity and incomes rise -> promoting private sector investment as firms seek to profit from activity
ALSO if infrastructure spending such as transport reduces costs for firms -> making them more efficient -> encouraging private sector investment if it is making them more competitive
5) Automatic stabilisers
If economy has; progressive income tax system AND welfare benefits
Can reduce need for expansionary fiscal policy on top of the stabilisers in a recession. The impact of stabilisers; greater G spending on welfare and lower average rates of taxation will cushion the negative impact on growth and unemployment, meaning Gov can limit borrowing and size of their budget deficits.
6) Size of the multiplier
The greater the size, the less the gov will need to increase spending or cut taxes in order to have a large favourable impact on AD, growth and employment. VICE VERSA if multiplier is small.
HOWEVER calculating multiplier is difficult and highly assumptive therefore basing fiscal policy decisions on it is dangerous with no garantuee of success
7) Laffer curve arguments
That increasing progressive taxrs on the rich will distort inscentives if they are beyond the efficient tax rate on the Laffer curve, meaning increases in tax rates woul decrease tax revenue and a cut in taxes would actually raise revenue for the government by promoting entrepreunerial spirit, inward migrationg and incentives to be more productive, improving gov finances
What are the ‘automatic stabilisers’?
Automatic instruments in place in an economy that can reduce fluctuations in the economic cycle : Income tax systems and welfare benefits.
Boom = Incomes increase -> increases average rate of tax for workers as more income is taxed at a higher rate in a higher tax band -> automatically controlling increases in consumer spending -> reducing rate og growth of AD -> restricting size of boom and inflationary pressure.
ALSO with more individuals employed -> goverment spends less on welfare payments -> further restricting G in AD equation -> reducing excessive inflationary pressure
Recession = Incomes fall -> decreases in average rate of tax for workers as less incomes is taxed in lower tax bands -> prevents how much consumer spending falls in economy -> reducing impact of AD decreases -> limiting size of recession and unemployment.
ALSO more unemployed -> Gov spends more on trasnfer payments -> increasing G in AD equation -> limiting size of AD reduction -> oreventing deep large recession
What is monetary policy?
Changes in interest rates, money supply and the exchange rate to influence AD in an economy
Why are interest rates signficant to economy? 2
-Changes in intereset rates affect inflation and can help gov meet inflation targets
-Money market interest rates are benchmark rates when financial institutions set interest rates for credit cards, general loans, savings accounts and mortgages -> hence why changes in interest rates will feed through to rest of economy
What diagram do we use for changes in interest rates?
see flashcard
How can central banks reduce interest rates? 3 (opposite for rise rates)
By increasing or decreasing the money supply in the economy
1) Reduce the reserve requirment
This is the level of reserves as a % of bank deposits that commercial banks must keep at the central bank. By reducing this, less money needs to be kept at central bank, increasing money supply from Sm1 to Sm2, reducing rates from i1 to i2
2) Reduce the repo rate
This is the interest rate charged to commercial banks when they borrow from the central bank. By reducing this, commercial banks have to pay less in interest to central bank, increasing money supply from Sm1 to Sm2, reducing interest rates from i1 to i2
3) Buy bonds using open market operations
Central bank can engage in secondary bond markets by buying up bonds held by commercial banks. Increasing money supply by replacing less liquid financial assets for liquid deposits, reducing interest rates
What is the expansionary monetary policy transmission mechanism? 5 (opposite for contractionary)
How does a reduction in interest rates result in an increase in AD
1) Reducing cost of borrowing -> cheaper to borrow -> increased disposable income -> increases C
2) Reduces rate of return on savings -> reduce incentive to save -> increase MPC -> decreasing saving ration in economy -> increasing C
3) Reduce monthly payments for those with tracker or variable rate mortgages -> these homeowners recieve boost to monthly disposable income -> increase MPC -> increasing C
4) Reduced cost of borrowing for firms -> easier to reach require rate of return for investment projects to go ahead -> increasing MPI -> increasing I.
This also improves quality and quantity of economies factors of production -> increasing LRAS
5) Hot money outlfows -> investors move money out of uk to look for bvetter rate of return elsewhere -> greater supply of UK pound as investors sell it -> weaking exchange rate -> WIDEC -> boosting (x-m)
What problems of expansionary fiscal policy can be overcome with expansionary monetary policy?
With monetary policy, there is no worsening of government finances
What are the cons of expansionary monetary policy? (3) What are the side effects of using monetary policy to boost AD
1) Infaltionary pressure
Infaltion is likely to increase from P1 to P2 as spare capacity in economy is exhausted therefore there is more competition for resources and [pressure put on exisiting factors of production, increasing their prices, causing demand pul inflation
2) keynesians argue that interest rates have a lower bound when economy is in a liquidity trap.
see flashcard for diagram
Where interest rates have already reached so low that individuals have already converted illiquid financial assets into liquid forms e.g cash, to spend on goods and services (this is where the money market demand curve, Dm, become flat; a liquidity trap)
Meaning traditional expansionary monetary policy to increase the money supply from Sm1 to Sm2 will not lower interest rates below i1, therfore fialing to stimulate borrowing, growth and jobs.
3) Large negative impact on savers
They recieve lower RoR on their assets -> for elderly who save most of their money in pension funds, this could severly imapct their living standards upon retirment -> leading to greaster wealth inequality
What are the pros of contractionary monetary policy? (6) Using monetary policy to decrease AD
1) Can control inflation
As interest rates increase -> C, I and (x-m) decrease -> reducing AD -> increasing level of spare capacity -> less pressure on exisiting factors of production -> reducing rate at which their price rises -> reducing demand pull inflation
2) Protects against credit/asset bubbles and systemic risk in banking sector
Periods of prolongued low interest rates could lead to excessive borrowing, driving up debt and asset prices beyond sustainable levels ->economy vunerable to negative demand side shock if asset prices were to fall -> households may default on loan repayments -> bank failure -> systemic risk as bank failure has ripple effect.
High interest rates reduce this risk
3) Make housing more affordable
Interest rates increase -> monthly mortgage payments become more expensive -> reducing demand for housing -> reducing housing prices -> benefiting first time buyers and lower incomes -> reducing wealth inequality
4) Promotes more sustainable lending and borrowing
Low rates attrace lots of borrowers regardless of if they are credit worthy -> lenders take excessive risk -> promoting long term dependancy on credit led consumption and investment.
5) Encourages saving and investment
RoR on savings rise -> increased MPS -> as more saving takes place -> banks have greater funds available to lend out in the form of loans to companies or entrepreneurs -> promoting short run and long run economic growth
6) Provides ability to lower interest rates in times of need
For example during next economic shock
What are the downsides to contractionary monetary policy? 6 (increasing interest rates)
1) Potential shock to economy
As AD falls -> growth decreases -> unemployment increases -> potentially resulting in recession -> therefore if economy is in a fragile state then central banks must be extremely careful
2) Indebted economic agents could ‘fall off a cliff’
Mortgage payers, consumers with credit card debt or firms could be reliant on low interest rates to afford repayments -> if rates rise they may default, harming living standards as assets are taken away whilst firms may have to shutdown
3) Bank failures
Households and firms are at higher risk of defaulting when interest rates rise -> risking bank insolvency
Banks could struggle to access liquidity from central bank at higher repo rates
Individuals could move savings away from standard accounts to more higher yielding assetts -> increasing risk of liquidity crisis
Systemic risk
4) Detracting borrwing for investment
Harder for firms to reach hurdle rate of return on investment projects as their is an increased cost of borrowin -> reducing firms marginal propensity to invest -> lower producitivty -> reducing quantity and quality of factors of production -> hampering LR economic growth
5) Risk of housing market crash
Indivduals defaulting + fall in demand for mortgages -> housing prices fall dramatically -> creating an economic shock -> negative wealth affect, lower C and a downturn in economy
6) Stronger exahcnage rate therefore deterioration of CA position
SPICED -> conflicting with a macroeconomic objective
What are the evaluation points for expansionary monetary police? (opposite for contractionary) 6
1) Initial level of economic activity
If large negative output gap (large level of spare capacity) = Increase in AD will lead to larger increase in output and decrease in unemployment, cuz w spare capacity it is easy for firms to expand production by using up excess unemployed labour and capital.
ALSO the lack of pressure will limit inflation
If low levels of spare capacity = Difficult for firms to find new workers and increase output, low increases in output and employment and large increase in inflation
2) Level of consumer and business confidence
If low = a reduction in intetest rates, regardless of how big, may have little impact on stimulating AD as consumer worry asbout their future employment prosepects, reducing MPC. Same with businesses concerned about lower profits
3) Time lags for monetary policy to have effect on economy
Widely accepted that interest rates take 2 years to have full impact on economy, feeding through transmision mechanism
4) Depends on size of interest rate cut
The larger the cut -> the greater the affect on consumer / firm behaviour AND greater consequences.
5) Whether banks are willing to lend and willing to pass on the full rate cut
In times of deep recession, when expansionary monetary policy is needed, banks may not be willing to lend or pass on the full rate of the cut as they are concerned about their liquidity and profitability -> thus minimal positive impact on AD
6) Depends on intitial level of interest rates
If cut from a high level (i.e. 5%) rate cut is more likely to have a postivie effect on boosting AD.
Interest rates falling from already low levels (0.75%) may be indicative of an already weak economy with low confidence levels, meaning it is unlikely to have a strong influence over C, I and (X-M)
What is quanitative easing?
An expansionary monetary policy where central bank creates money to buy financial assets to stimulate economy and increase liquidity.
When is QE normally used over traditional expansionary monetary policy?
A method of increasing money supply to boost AD and thus raise growth and unemployment when traditional monetary policy (interest rates) has reached its lower bound or has failed to stimulate economy due to banks not willing to lend/pass on rate cut.
How does QE work?
1st) Central Bank electronically creates more money and adds it to their balance sheet
2nd) Central bank uses money to buy financial assets (mainly government bonds) from financial institutions
3rd) This drives up price of bonds and decreases their yield
4th) Insitiutions from whom the bonds have been bought now have large amounts of cash, they use to buy up other assets with better yields than bonds
5th) This once again drives up price of these assets and reduces their yields
6th) As yields (long term interest rates) accross the economy fall, insitutions look to invest in more riskier options
7th) If they invest in shares = can stimulate consumption if consumers/households are holding shares in that company
If they invest in cooporate bonds = yield on these bonds decreases
8th) As yield on cooporate bonds decreases, this decreases costs for the issuer which is banks, increasing banks incentive to lend
9th) Access to credit in the economy improves, with lower general interest rates, passed on to consumers / businesses
10th) This stimulates borrowing, spending and investmnet
Boostin AD, increasing growth, reducing unemployment
11th) As cash floods into bonds, shares and houses, price increases -> triggering wealth affect -> increasing C
12th) Increasing money supply -> weakens exchange rate -> WIDEC -> improvement in CA balance -> boostin (X-M) -> boosting AD
What are the cons of QE? 4
1) Infaltionary pressure
Infaltion is likely to increase from P1 to P2 as spare capacity in economy is exhausted therefore there is more competition for resources and [pressure put on exisiting factors of production, increasing their prices, causing demand pul inflation
2) Banks may still not be willing to lend
Particularly in times of deep recession or financial crisis, may be concerned about liquidity and profitability. Low willigness to take risk -> reducing their willigness to lend
EVEN IF WILLING TO LEND -> may still charge higher interest rates if they are averse to risk -> reducing borrowing incentives and thus the positive impacts on AD
3) QE drives wealth inequality
Money goes into buying shares, bonds and houses -> driving up prices of these assets -> increasing wealth inequality
4) Negative impact on savers
Bond prices rise, their yield falls -> those who have saved in government bonds or pension funds where bonds are a major investment will receive a lower return -> discouraging savers and saving
What is quantitative tightening?
The reverse of QE, reducing money supply from QE to decrease AD and reduce demand pull inflationary pressure in economy.
Is necessary once QE has stimulated growth and promoted recovery
How does QT work?
1st) Central bank sells holdings of bonds and allows existing bonds to mature
2nd) This money from selling their bonds is removed from their balance sheet (destroyed), reducing the money supply
3rd) Greater supply of bonds in market -> price of bonds falls and yields rise
4th) Returns (coupons) on cooporate bonds need to rise to match higher yields and compete, making it more expensive for banks to raise finance and lend
5th) Higher borrowing costs are passed on via higher interest rates on consumer and busienss loans -> reducing C and I -> reducing AD
What are the cons of quantitative tightening?
If done too quickly and on a large scale =
Could create a tradeoff with lower growth and higher unemployment, while starving financial sector of liquidity to lend.
Also risks to government borrowing costs if yields on bonds rise too quickly
What are interventionist supply side policies? What diagram do we use?
Government promoting policies that aim to shift LRAS to the right by increasing the economy’s productive potential.
Classical LRAS diagram with no SRAS and a LRAS shift right, increasing Yfe
What are 3 intervenstionist supply side policies and how do they shift LRAS?
1) Government spending on education and healthcare
I.E Apprenticeship schemes, adult re-training, school curriculum reform and healthcare spending -> improving skills and productivity of labour force -> boosting human capital -> increasing quality of factors of production -> reducing structural unemplyoemnt by providing skills to fill job vacancies in the economy -> increasing quality of labor and thus LRAS
2) Government spending on infrastructure
Transport infrastructure -> reducing costs of production for firms as transporting goods/services accross economy becomes quicker and more efficeint -> imrpoving productive efficiency and competitiveness -> increasing LRAS
3) Government offering subsidies or tax allowances to increase incentive for firms to invest -> spend on new capital, upgrade machinery, build new factories, inprove RnD ETC -> improving both quality and quantity of capital stock in economy -> improving prodcutive efficiency -> increasing LRAS
What are market based supply side policies? What diagram do we use?
Policies that reduce the role of the government, aiming to shift LRAS right by increasing economies productive potential.
Classical LRAS with no SRAS and LRAS shifting right
What are the different types of market based supply side policies to boost LRAS? 3
Tax reforms
Labour Market reforms
Competition Policies
What are the ‘tax reform’ market based supply side policies? 2
1) Reducing marginal rate of income tax
Increases incentive to work harder as less income will be taxed -> boosting labour productivity -> improving quality of factors of production
Incentivises economically inactive to start working and take available jobs -> improving quantity of factors of production
2) Reducing cooporation tax
Increasing incentive for firms to invest -> more retained profit to do so -> new capital, upgrading machinery, new factories etc. -> improving quality and quantity of capital stock in economy -> boosting LRAS
What are the ‘Labour Market reform’ market based supply side policies? 4
1) Reducing power of TUs
Lowers LR costs of production for firms -> imrpoving efficiency in labour market -> improving quality of factors of production -> boosting LRAS
2) Reducing min.wages
REducing costs of production for firms where min wages are paid such as retail, hospitality, leisue etc -> improving efficiency of labour market -> improving PE of firms -> improving quality of factors of production
3) Redcuing unemployment benefits and 4) relaxing immigration controls
Both boost quantity of factors of production in economy, directly and through incentives
What are the ‘competition policies’ market based supply side policies? 3
1) Privatisation
Creates profit motive -> more firms enter, increasing comp -> incentivises maximum efficiency -> firms aim to lower costs of production -> immrpoving productive efficiency -> improving quality of factors of production
2) Deregulation
Increased competition in industries -> incentivises maximum efficiency -> firms aim to lower costs of production -> immrpoving productive efficiency -> improving quality of factors of production
ALSO lowers costs of production for firms -> improving efficiency -> imrpoving quality
3) Trade liberalisation
Removal of trade barrier -> promoting global compeition -> forcing deomestic firms to be more efficeint to compete -> improving productive efficiency -> imporving quality
What are the cons of supply side policies? 5
1) Very costly
I.E spending on infrastructure -> huge opportunity cost
2) Long time lag
I.E improvements in education / trainign can take w a while to improve productivity of workforce and boost productive capacity of economy
3) Not guaranteed to work
No guarantee that subsidies and increase in tax free investment allowance will actually lead to an increase in investment, may use subsidy / excess income to deleverage, wage rises, dividends etc.
No guarantee that competition policies will actually reduce costs and increase efficiencies.
This, coupled with goverment cost of implementing policies = no benefit in macroeconomic objectives and strong opportunity cost
4) Negative impact on key stakeholders
Deregulation can harm workers, may suffer from worse working conditions -> may harm consumer through lower quality standards
General population will suffer if pollution policies are relaxed.
Poor will suffer without minimum wages, strong TUs and welfare
5) Effectiveness depends on initial level of economic activity
If economy is already operating with large levels of spare capacity, it will be more effective for expansionary demand side fiscal policy or monetary policy to stimulate AD by using up spare capacity. Supply side policies will merely increase potential ouput, which isnt useful if there is a large negative output gap.
What is macroeconomic peformance?
The ability for an economy to achieve all 4 key macroeconomic objectives of government:
-Strong, sustained growth
-Low unemployment
-Low and stable inflation
-Balanced trade position
What types of policies do we implement to increase short run economic growth?
Expansionary monetary and fiscal policy
What policies do we implement to increase long term economic growth?
Intervensionist supply side policies
Market based supply side policies
What features of an economy would require increases in short term economic growth (AD) or long term economic growth (LRAS)?
If a country has a negative output gap = demand side policies are needed to boost AD without a large inflationary side effect
If country has very little spare capacity = Supply side policies are needed
What policies can be used to reduce cyclical unemployment?
Expansionary fiscal and monetary policies, closing output gap in economy.
AD increases -> demand for goods and services increases -> labour is derived demand
What policies can be used to reduce structural unemployment?
Supply side policies are needed.
Interventionist =
-Spending on education -> occupational imobility
-Subsidising work training programs -> occupational imobility
-Grants / low cost housing -> geographical imobility
Market based =
-Deregulation, reducing hiring/firing laws, reducing TU power, reducing mininmum wage -> Easier for firms to hire low skilled workers
-Reduce level of unemployment benefit -> force workers to move, geographical imobility
What policies can be used to reduce frictional unemployment?
Supply side policies are needed.
Interventionist =
-Providing more and better resourced job centres -> improving job information -> allowing frictionally unemployed to fill vacancies quicker
Market Based =
-Reduce level of unemployment benefit -> motivating people to spend less time out of the workforce
What are the evluation points for using policies to reduce unemployment? 3
1) Most appropiate policy depends on type of unemployment that is excessive in economy.
If large negative output gap, in recession, then expanisonary demand side policies are needed to reduce cyclical unemployment
If close to Yfe and natural rate of unemployment is too high, targeted supply side policies are needed to reduce structural and frictional unemployment
2) Whether to implement policies or not depends on the level of unemployment
If at natural rate, can be argued that benenfits of unemployment outweigh costs therefore no policies are necessary
3) It is difficult for government to know the exact types of unemployment that are occuring in economy
What policies can be implemented to reduce demand pull inflation?
Contractionary monetary and fiscal policy to reduce AD and relieve pressure on existing factors of production, feeding through to lower prices in economy
Which type of policy is more effective ad reducing demand pull inflation?
It is agreed that MONETARY POLICY IS MORE EFFECTIVE at reducing demand pull inflation than fiscal policy
This is why there is an inflation target madate imposed on central banks, but as there is a huge conflict with other macroecnomic objectives when imposing contractionary fiscal policy, central banks also have macroeconomic stability madates to prevent recessionary impacts
What policies can be used to reduce cost-push inflation? What diagram do we use?
Diagram = Classical with SRAS shift left, no LRAS
1) Implement an inflation target or reduce it
This reduces inflationary expectations -> wage expectations and wage bargaining will be lower -> reducing rate at which cost push inflation increases as SRAS shifts right
2) Reducing VAT, Fuel duty and / or offer subsidies to firms
Reducing their costs of production
EVAL = this will have negative impact on government finances -> opportunity costs
3) Intervene in FOREX markets to strengthen exchange rate
Increasing interest rates to attract hot money inflows, selling foreign currency and buying domestic currencies -> making imports cheaper -> reducing costs of production for firms who are reliant on imported raw materials
EVAL = Will harm CA position, reducing AD as (X-M) decreases. reducing economic growth and unemployment.
Central banks tend not to do this as it harms 3 macro targets and worsens international relations, could cause retaliation action
What policies can be implemented to reduce long term inflation due to a lack of spare capacity?
Supply side policies that increase LRAS
What are the evaluation points for using policies to reduce inflation? 3
1) Most appropiate policy depends on type of inflation
Demand pull = short term solution using contractionary fiscal/monetary policy
Cost push = supply side policies
2) In reality knowing where inflation is coming from is very difficult
Therefore policy makers are likely to use a range of policies to keep inflation low and stabel at the target rate.
3) The rate of inflation will determain if policies are needed
Low and stable can be healthy for economy with benefits outweighing costs.
If rampant, costs outweigh benefits, justifying policies
