Effectiveness of Macro Policies Flashcards
Laffer
evaluation for more progressive tax system to reduce inequality
DRAW LAFFER CURVE
Laffer suggested that as tax rate increases, tax revenue will rise until you pass the optimum tax rate where tax revenues are maximised. Tax revenue begins to fall (EXPLAIN THIS MOVEMENT USING POINTS ON YOUR DIAGRAM)
Because (1) the incentive to work reduces
This could worsen inequality because the highest-earners are likely to be business owners, who may shutdown and relocate to a place with lower corp tax - likely to occur in today’s globalised economy
This will lead to fewer jobs available and higher unemployment, reducing incomes and worsening inequality
and (2) tax evasion/avoidance occurs, as the fiscal dividend would reduce and leave less for the govt to spend on public services that low-earners depend on
explain the laffer curve argument
- increasing the tax rate will increase tax revenues up till a certain point where they are maximised
- increasing tax rates beyond this point will reduce tax revenue due to reduced incentive to work (and brain drain) and tax evasion/avoidance
- in this way, tax cuts may actually increase tax revenue
evaluate the laffer curve argument
- likely to be reasons other than high tax that people live in a country, e.g. safety, political stability, family ties
- ignores attitudes towards work and leisure which are likely to vary between countries of different income levels
- government enforcement could prevent tax evasion/avoidance
- effect of tax cut depends on SIZE of cut and current rate
- empirical evidence of causing govt failure: Ronald Reagan enforced tax cuts that actually REDUCED tax revenue - unexpected reactions of people
explain the liquidity trap
interests rates may have lowered to such an extent that they can’t be lowered anymore
occur when IR are low and bond prices are high so individuals expect price to fall in the future and therefore an increase in money supply would mean people hold the extra money to buy bonds in the future
at this IR, the demand for money becomes perfectly elastic and an increase in the money supply has no effect on the IR or increasing AD
explain crowding out
higher government spending financed by increased borrowing will reduce loanable funds for the private sector and increase the interest rate, increasing the cost of borrowing for private sector consumption and investment
list the government macroeconomic objectives
RUBIES
- Redistribution of income and wealth
- low unemployment
- balance of payments stability (current account)
- low and stable inflation
- Economic growth and development,
- which is Sustainable
what influences whether a country can meet its inflation target or not?
- importing essential inputs like oil from countries with high inflation
- high inflation in trading partners reduces incentive for domestic producers to keep prices low
- fiscal/monetary policy, which also depends on other countries - disincentives due to high income tax (brain drain) or interest rates
why is low inflation important?
- remain internationally competitve
- maintain consumer and business confidence to encourage consumption, investment, trade and economic growth
- allow consumers to maintain stable purchasing power and SOL
why is CA stability important?
- large deficit is a leakage from circular flow, reducing AD
- may increase external debt to finance
- surplus can be inflationary as net X will increase AD (INJECTION)
- fluctuations will affect ER, increasing uncertainty and lowering confidence for trade, investment and growth
why is low unemployment important?
- less output is lost as labour is used more productively
- lower govt spending on UE benefits (OC)
- fewer workers experience loss of income - maintain stable SOL
- workers will not be UE for long so won’t miss much training/tech changes (hysterisis)
why is sustainability important?
- to ensure economic growth and rises in income and prosperity can be sustained in the LR
- high levels of pollution/waste/degradation will reduce the quality of life for future generations! Development outcomes
why is redistributing income and wealth important?
- to reduce LT income inequality and poverty and increase SOL in society by boosting access to essential G & S
- could increase the rate of economic growth as more people experience higher disposable incomes
explain the relationship between the internal and external value of money
IV = domestic purchasing power
EV = ER, price of one currency ITO another
- increase in inflation will reduce IV, but also EV as exports become less price competitive and the currency depreciates
- inflation will not affect EV IF ER is fixed and not being devalued, and if inflation rises by RELATIVELY less than trading partners
explain the relationship between the BOP and inflation
- higher relative inflation (fall in IV) will increase CA deficit as export revenue falls
- increase in CA surplus will increase inflation (AD) in the short run
- net inflow on financial account will reduce inflation in LR if MNCs introduce new tech that reduces costs and puts more pressure on domestic producers
explain why an increase in a CA surplus will only increase inflation in the SR
- increase in surplus will cause currency to appreciate
- as imports become cheaper in domestic terms, the cost of imported inputs falls, feeding through to both domestic and exported products
- as exports become dearer, there is more pressure on domestic producers to cut costs and prices to stay competitive with foreign rivals
relationship between economic growth and inflation
- actual growth will increase demand pull and cost push inflation in the SR as incomes and AD rise (economy approaches YFE)
- potential growth will reduce inflation in the LR
- higher inflation will reduce growth as (X-M) falls and thus AD - output, employment and growth declines
relationship between growth and BOP
- actual growth in GDP can result from higher (X-M) through the multiplier effect
- potential growth can increase price and NP competitiveness and increase (X-M), having multiple increase in real GDP
- in the SR, higher growth may be achieved by imported more raw inputs and capital, reducing (X-M), but as more output is produced and exported, this may be offset as (X-M) rises
explain the relationship between inflation and unemployment using the Phillips curve
Keynesian idea - lower unemployment will increase inflation as AD increases and puts upward pressure on wages and other prices
reducing UE from a very high rate will not increase inflation significantly as there will be a negative output gap and high spare capacity is being used up
reducing UE from a low rate to an even lower rate will accelerate inflation significantly, as wage and price pressure rise and the output gap becomes positive
evaluate the Phillips curve model
Monetarists believe this inverse relationship is true only in the SR and not in the LR
as the economy returns to its NRU in the LR, an increase in AD will not reduce UE and only increase inflation
explain the long run Phillips curve, AKA the expectations-augmented PC
- an increase in AD will reduce UE to below the NRU and increase the price level, moving up the SRPC
- the increase in inflation will make worker revise their wage expectations upwards, shifting SRAS left as COP rise
- this increases price level further and shifts the SRPC right, as inflation is now higher at every level of UE due to higher wage costs
- UE has thus returned to the NRU, creating a vertical LRPC
- the economy always returns to NRU will in the LR despite SR deviations as this is the point where all FOP are being used at sustainable levels
what does the LRPC tell us about increasing LR growth and employment?
increasing AD with DS policy is ineffective in the LR as inflation will continue to rise with no impact on employment
must use SS policy instead to reduce the NRU and shift the LRPC to the left so that growth can increase sustainably without increasing inflation
in questions about the relationship b/w inflation and UE
evaluate using SR and LR impact!!!!!!!!!
evaluate the use of fiscal policy
- expansionary policy will create tradeoff between growth and employment, and inflation and BOP
- crowding out (BUT crowding in!)
- Laffer’s argument
- tradeoff between redistributing income and the incentive to work
- increasing indirect taxes has a regressive, inequitable impact
- unexpected responses - MPS, MPI, dividends, deleverage
- time lag
- inflexible govt spending (stopping/reversing)
- counteracting policies - monetary
- initial level of econ activity (output gap)
- impact of spending depends on state of govt finances
- size of multiplier
- role of automatic stabilisers
explain crowding in
Keynesian idea that higher govt spending will actually increase GDP by a multiple amount, increasing incomes
this will increase savings, providing more loanable funds at lower IR
higher incomes will also increase confidence to consumer and invest (higher MPC and MPM)
public sector spending will therefore increase private sector investment
evaluate the use of monetary policy
- time lag of transmission mechanism
- QE/lower IR will not work if banks are pessimistic (do not lend or charge higher rate)
- QE used instead of IR in liquidity trap
- unexpected reactions
- consumer and confidence - Keynes said animal spirits matter more than IR
- initial level of econ activity - output gap
- size of rate cut
- counteracting fiscal policy
- international influence - foreign banks may lend at lower IR, or foreigners save in domestic banks and lower IR and increase loanable funds
define market-based supply-side policy
tools that increase the role of market forces, categorised mainly as either tax reform, labour market reform or competition policies
LIFE (labour markets, industry, free market)
tax reform
- lower income tax - incentive for economically inactive to join labour force; those already in work increase productivity
- lower corp tax - higher retained profit to invest
labour market reforms
- reduce welfare benefits - incentive for economically inactive to enter labour force
- reduce MW - reduce COP and productive efficiency
- reduce TU power - reduce COP and productive efficiency
competition policy
- privatision
- deregulation
- trade liberalisation
increasing competitive pressure will increase the incentive to improve productive efficiency and lower COP
define interventionist supply side policy
involves government taking a larger role in the economy by spending on education, training, infrastructure and tech improvements, and subsidies to firms to increase R&D
aims to overcome market failures that reduce AS
evaluate the use of MBSSP
- increase inequality
- may not increase emploument
- unintended effect of reducing LR econ growth
evaluate cutting income tax to increase AS
- cutting income tax will have less of a benefit for lower-paid individuals who may remain within the tax free allowance, but will increase the incomes of the richer, thus increasing inequality
- does not guarantee increased employment as vacancies may be unavailable, people may lack required skills and quals or may face geo immobility
- may not improve work incentives - workers deciding to maintain current income and take more leisure
evaluate lower corp tax to increase AS
may not use to reinvest, but rather deleverage or pay higher dividends
evaluate cutting benefits to increase AS
- low-income households depend on benefits for disposable income to spend on essential G/S
- does not guarantee increased employment as vacancies may be unavailable, people may lack required skills and quals or may face geo immobility
evaluate privatisation to increase AS
- privatised firms charge higher prices - regressive impact, increases inequality
- those buying out public industries increase their wealth and hence incomes
- increase in efficiency depends on competition and contestability - may become monopoly
evaluate deregulation to increase AS
- worker exploitation removing health and safety rules, zero-hour contracts, lower pay, lesser upskilling/training
- this will also reduce labour productivity, welfare and LR econ growth - NOT SUSTAINABLE
- removing a NMW will reduce relative pay and increase inequality
- may increase negative externalities - environemental damage
- may lower consumer welfare- lower quality to cut costs
- increased instability - financial markets and 2008 crisis!
evaluate labour market reforms to increase AS
- reducing MW or TU power may result in lower wages and poorer working conditions
- increase inequality but possibly harms workers, reducing productivity, growth and welfare in the LR
evaluate interventionist SS policy
- time lags and risk of redundant action (e.g. skills requirements change once education complete)
- COST: opportunity cost; risk of government failure; funding with debt, higher tax or cutting spending elsewhere
- workers may not participate in training schemes
- externalities of building infrastructure - pollution
- advancing tech and certain skill sets may cause structural unemployment
- if negative output gap, not effective
- effective as long as TARGETING SPECIFIC ISSUES, SO REALLY DEPENDS ON THE EXACT ISSUES ECONOMY FACES - e.g. poor infra, lack of competition, low employability
unlike MB SSP, IB policies…
increase both actual and potential econ growth
policies to suggest for education and training
- school curriculum reform
- building new schools
- training teachers
- apprenticeship schemes with tax benefits
- vocational training programs
how do both MB and IN SS policies work?
by increasing:
- quantity of FOP
- quality of FOP
- productivity efficiency (COP)
and this shifting LRAS to the right! USE A DIAGRAM
this is what you need to link your policies to in the end of your analysis
policies to suggest for spending on infra
- new transport infra, e.g. roads, airports, railways, bridges are built/improved
evaluate the effectiveness of ER policy
- causes trade off b/w/ BOP and indlation
- PED of M and X will determine changes in expenditure/revenue following change to ER
- speculation offsets
- retaliatory offsets
- competitive devaluation to lower X prices may only work in SR as WIDEC causes inflation (needs sturcutral change)
- availability of FOREX to manipulate currency
pros of protectionism
- protect infant industries (allow to grow, exploit EOS and compete)
- protect against domestic structural employment
- discourage dumping
- improve CA deficit
- protect strategic industries like food/fuel to avoid foreign reliance
evaluate trade protectionism
- retaliation and trade wars
- could damage domestic inefficiency incentives (dependency)
- being part of a trade bloc may limit protectionism measures on other members
- if using tariff/subsidy, depends on PED for M/X
- depends on the extent of the measure imposed
define government macroeconomic failure
- govt intervention reduces rather than increases economic performance as per the main macro objectives, thus worsening economic efficiency
when question refers to ‘economic performance’ or ‘macro stability’, it means….
the achievement of the macroeconomic objectives in a way that is sustainable and limits the trade off b/w other objectives
what are the 5 main reasons for govt macro failure
- miscalculating the multiplier - enforcing DS policy too heavily/too lightly
- time lags
- unexpected/no reaction
- desire for political popularity in elections
- corruption
how does miscalculating the multiplier cause govt failure?
if underestimates it, for e.g. then may increase govt spending by too much
this will mean that the previous problem of negative output gap is replaced by problem of positive output gap - inflation and unsustainable growth
why are time lags a cause of govt failure?
by the time a policy tool takes effect, economic activity may have changed due to the business cycle and policy tool may do more harm than good as it fails to act COUNTER-CYCLICALLY
it reinforces the stages of the cycle, e.g. worsening a recession by reducing AD, instead of offsetting it
give an example of how govts may fail due to unexpected reactions
- training schemes as an IBSSP may fail if workers have no incentive to attend the scheme
- animal spirits may influence consumer/firm behaviour more than IR
- cutting corp tax may result in higher dividends/deleveraging instead of investment in R&D
- deregulation/TU reform to increase employment won’t work if there are no vacancies available or if people lack the correct skills. Govt should have reinforced with appropriate training programs
how does desire for political popularity cause govt failure?
when elections are approaching, govts may introduce popular policy tools like increasing govt spending on pensions even if it will worsen economic performance by increasing inflation and worsening the fiscal deficit
how can corruption cause govt failure?
governments make inefficient use of reosurces (especially tax revenue) by using for their own benefit rather than economy’s benefit
e.g. in Honduras efforts to reduce income inequality and improve education and health were hindered by officials stealing from the govt budget
explain tradeoff b/w UE and growth, and inflation
can reduce DP inflation using contractionary DS policy, but this will reduce growth rate and increase UE
can overcome using SSP that improve all 3 IN THE LR
explain the tradeoff b/w inflation and the BOP
may increase IR to lower inflation, but this will cause appreciation of ER due to hot money inflows
will not only reduce growth and employment, but will worsen CA by increasing M expenditure and reducing X rev
explain the trade off b/w redistributing income and economic growth
making income taxes MORE progressive and increasing welfare benefits may distort incentives to work and enterprise, as well as cause brain drain as labour and entrepreneurs move overseas
BUT… (may be ST if used to improve ed and health and thus labour productivity; work and enterprise influenced more by wage rates, profits and general macro stability; FDI attracted regardless if demand and labour productivity is high in country)
how do govts overcome tradeoffs b/w objectives?
- use a combo of fiscal, monetary and SSP, a separate tool for each objective
- e.g. cut income tax to reduce UE, but also devalue currency to improve CA
