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!!!!!!!!!
