Government Objectives & Policy Instruments Flashcards
Briefly explain all types of Macro Policies
Aim: Increase Growth
Demand-Side Policies ↑AD :
- Fiscal Policy (↑G &↓T)
- Monetary Policy (interest rates, money supply, inflation)
Supply-Side Polices ↑AS
- Interventionist (government intervention)
- Free Market (let markets work)
Explain Fiscal Policy
Fiscal Policy is the use of government spending, taxation and borrowing to influence AD. Fiscal policy can be expansionary or deflationary
Gov Spending = Tax + Borrowing
Tax provides an income for the gov, so if gov spending is greater than tax income then the gov will have to borrow the difference. This is known as the budget deficit or fiscal deficit. Each year the gov borrows, the total “National Debt” rises.
Fiscal Deficit or The Budget Deficit: Tax - Gov Spending
Expansionary fiscal policy is where the gov boosts AD (and so Y) by increasing spending/cutting tax (always increases the budget deficit/National Debt)
Deflationary fiscal policy is where the gov decreases AD (and so Y) by decreasing spending/increasing tax (austerity measures)
How does fiscal policy work?
- Changing G will change AD, ad G is a component of AD and an injection into the circular flow
- Changing direct tax rates (especially income tax) will change disposable incomes and so change C
There will also be a multiplier effect of fiscal policies. This may vary, depending on where the gov spends the extra money/cuts tax (or vice versa)
Problems and Issues with Fiscal Policy: (8)
- Deficits: an expansionary policy needs to be financed by borrowing. This has 2 problems: in the most extreme case the gov may be unable to raise the finance. More likely, the more it borrows the higher rate of interest it will have to pay. This means in the future it will have to charge higher taxes to cut spending in other areas to pay the money back
- Inflexibility: the gov sets tax rates once a year (the budget). If the changes in G and tax have a larger/smaller effect than they hoped it is difficult to change the policy until the next budget
- Time lag: it takes time for changes in fiscal policy to have an effect: 12-18 months. This is partly because new spending isn’t all done at once. Partly because people don’t change their spending instantly
- Crowding out: if the gov uses resources it means fewer resources (or more expensive resources) for the private sector to use. This is particularly important in the labour market (more D for labour from the gov pushes up wages and so private firms have to pay higher wages, which increases their costs & shifts SRAS) and capital or money market (more D for borrowing from the gov pushes up the cost of borrowing, or interest rates, which then reduces C,I and Net X). Ultimately this means that G may replace private spending rather than add to it, so an increase in G does not lead to (or only leads to a very small) increases in AD
- Elasticity of AS: the elasticity of the AS will determine the impact of fiscal policy on Y and PL. The more inelastic AS, the greater the impact on prices and less on Y. (Keynesians say this occurs when an economy is at near full capacity. Classical economists say the LRAS is perfectly inelastic so fiscal policy will never affect Y in the LR)
- Ricardian Equivalence: this idea says if the gov runs up a debt people will know this means higher taxes in the future and so save money to prepare for this so C falls. There is little evidence this actually occurs in reality
- Impact on AS: if G increases it may have a LR impact on LRAS - more spending on education or infrastructure or healthcare should shift the LRAS. In the SR changing indirect tax rates (VAT etc) affects firms costs so shifts the AS
- Impact on Exchange Rates: if the gov wants to raise finance by selling bonds to foreign investors they will demand more pounds. This increase in demand will push ip the value of the pound and leads to a fall in (X-M) and AD
Explain Monetary Policy
Monetary policy is the process by which a Central Bank (or government) may try to control the supply of money and in particular refers to influencing interest rates.
In the UK the Monetary Policy Committee (MPC), part of the Bank of England, controls policy. The MPC meets once a month and decide on the interest rate the Bank of England will set: the base rate. Usually the change is very small 0-0.25%, however since 2008 it hasn’t changed and stayed at 0.5%
MPC has an inflation target set by the gov 2% ±1%
Tight MP - increasing interest rates
Loose MP - decreasing interest rates
How do Central Banks make decisions?
Assuming they are currently meeting their targets, they predict what is going to happen in the future and try to counter-act that. So if they think that consumer confidence will rise in the future, so ↑C ->↑AD -> a rise in PL (inflation above 2%). They will then use monetary policy to reduce AD, so counter-acting the effect of rising consumer confidence and keeping the prices the same
How does Monetary Policy work?
Monetary Policy is all about controlling the amount of saving and borrowing done. There are 3 ways a CB can influence this:
- Setting the interest ‘base rate’ or ‘discount rate’
- Printing money - Quantitative Easing (QE)
- Setting reserve requirements
How do interest rates affect AD?
There is an inverse relationship; higher interest rates means lower AD, low i(rates) means high AD
The discount rate is the interest rate charged by the Central Bank to banks that borrow money from them. In theory (and most of the time in reality) if banks can borrow from the CB at a lower rate, they will lower the rate to their own customers. So interest rates for firms and consumers/savers will fall. This impacts AD in a variety of ways:
Consumption:
- lower interest rates makes borrowing more attractive so ↑C
- lower interest rates makes saving less attractive, so ↑C
- lower interest rates makes it easier to buy housing (cheaper mortgages), so increases demand for housing, so increasing houses prices. This creates wealth effect, so ↑C
- those who have already borrowed have to pay back less, so have more disposable income, so ↑C
Investment:
- lower interest rates make borrowing more attractive and means the return on more investments is greater than the interest rates, so ↑I
- lower interest rates makes saving less attractive, so firms are more likely to invest retained profits, so ↑I
Net Exports:
- lower interest rates means there is less return on holding a currency. Currency traders will then sell the currency (hot money flows) to buy a currency with a higher return. This increases the supply/reduces the demand for the currency and so its price falls; a depreciation. As we know, a weak currency means cheaper/more exports and more expensive/less imports. So ↑(X-M)
↓i ->↓”hot money demand” for € = ↓D€ ->↓P€ ->↑Pm ->↓M -> ↑(X-M)=↑AD
How does Quantitative Easing work?
Quantitative Easing is the official term for the CB printing money. The basic idea is that this will increase the supply of money, which will reduce interest rates (and so have the same impact as ↓i), given that interest rates are just the ‘price of money’.
In reality CB needs to get this extra money into the economy. QE doesn’t actually involve printing physical banknotes, but simply creating electronic money. This money is then put into the system via the banks. The CB will buy assets from banks (government bonds, asset backed securities) (QE is also knows as ‘Asset Purchase Facility’ or similar), the banks will then have cash (rather than assets) and so will lend out this cash. In order to convince people/firms to borrow the bank will have to cut the interest rates it charges… and so QE affects AD
Evaluation of Monetary Policy: (10)
Two general points: firstly, monetary policy was seen as hugely successful form 1998 to 2007 and was the basic instrument of government policy in a period where the UK had a long period of stable growth with low inflation so. The crunch/crash in 2008 has led to some questioning this, while others believe the events of the crunch were special circumstances. Secondly, you should remember the MPC/ECB has an inflation target only - it doesn’t care about growth (other than how it impacts inflation)
- Often different data suggests different things are happening. This makes it very hard for the CBs to know what is happening in the economy (ie are we out of recession yet or not?) and therefore hard for them to know what to do with interest rates
- The impact on real output (Y) and price level depends on the elasticity of the AS curve (same as fiscal)
- The impact on AD depends on the size of the multiplier (MPC, confidence…)
- Time lag: decisions are made on past data and the full effect of a change may not be seen for 18-24 months
- No guarantee that ‘high street banks’ will pass on the cuts (although they usually do). This was a problem in 2008 when the MPC cut the base rate but the LIBOR (the rate at which banks lend to each other) actually rose
- Lending policies of banks are also important
- Monetary policy is fine when dealing with inflation caused by increased AD, but what if it is caused by decrease in AS? Decreasing AS forces prices up but also Y down. Monetary policy would ↑i , which reduces AD and therefore pushes Y down even further. Is this “double-whammy” for Y a price worth paying?
- Liquidity trap. This is a Keynesian idea, where when expectations/confidence in an economy is low, cuts in i do not increase I, as people would rather hold the cash as a form of security (speculative balances)
- QE - has been criticised as it is giving more to banks and therefore there might be better ways to get this ‘new money’ into the economy. For example the gov could set up its own bank and lend out money itself
Explain Supply Side Economics
- 2 approaches
- 3 areas
Supply Side Policies (SSPs) are aimed at shifting the LRAS curve to the right. This means increasing the productive potential of the economy. This in turn means either ‘more factors of production’ or higher productivity from existing factors. Higher productivity = lower costs per unit of output = firms willing to supply more, at the same price level.
There are 2 basic approaches:
- Interventionist (ie gov intervention to promote AS)
- Free Market (ie a belief that the market/competition encourages efficiency/productivity)
There are also 3 basic areas where the gov can act:
- The labour market (reduce labour costs/increase productivity)
- The capital market (increase investment/productivity)
- The goods market (increase competition/productivity)
Give examples of Free Market SSPs with evaluation: (9)
- Deregulation of the labour market: this could include policies like remove/lower the NMW, reduce trade union powers, remove laws in max working week, change/remove laws on min&max working (retirement) age. All of these should help the labour market be ‘more flexible’… which is a nice way of saying firms can lower wages/cut FoP costs
BUT: labour market regulations serve a purpose. The NMW is to reduce poverty/exploitation of workers, TUs defend workers against stronger ‘bosses’, working ages are to ensure education/health care etc - Reduce state benefits: workers would be more willing to take low paid jobs if state benefits were very low. An alternative is to offer tax credits to those who take low paid jobs
BUT: the vast majority on benefits would rather be working, there are just not enough jobs for everyone sometimes. Lowering benefits isn’t going to motivate them and just increase their poverty - Reduce the ‘marginal rate of tax’: this is the % of tax paid on the last € of income. So if the marginal rate is increased then a worker would take home less pay: it is a disincentive to work or effectively a pay cut. Some even believe that reducing tax can increase the gov total revenue (the Laffer Curve)
BUT: is this true? Will a worker put less effort in just because he knows that he gets taxed? - Increased immigration: again increases the labour supply and should reduce wages. If the immigrants are well qualified (as on average they are) it should increase the skill level within the UK
BUT: the lower wages means lower AD… and what if immigrants do not/are not allowed to work? - Reduce Corporation Tax: corporation tax is the tax on a business’s profits. This profit can then be reinvested to make even more profit in the future, so lower Corp Tax may mean greater future investment
BUT: the extra profit might just be paid to shareholders or saved by the firm There may be no extra investment. They may buy their own shares - Free Trade: foreign competition forces domestic firms to be more efficient
BUT: domestic firms might be forced out of business by more competitive foreign firms - Privatisation: govs do not aim to make profit and do not have to be efficient. They should not run businesses! State businesses should be sold to the private sector and will become more efficient
BUT: in many countries there is little left to privatise. Also is there any guarantee the private sector firms will run the industry better than the gov did? - Deregulation: this removes rules preventing competition. Many industries are controlled with high levels of regulation (“natural monopolies” like rail track even have price caps set by the gov), other industries have regulations preventing/making it difficult for new firms to enter (4G, banking). In theory the removal of regulations will cut costs for businesses and allow new entrants/increase competition (both ↑AS)
BUT: many of these regulations also serve a useful purpose - preventing firms exploiting monopoly power or ensuring they behave in a reasonable manner (ie making sure banks keep a certain % of capital reserves) - Encouraging small businesses: new businesses provide competition for existing business, even the threat of new entrants in a market can force firms to become more efficient (theory of contestability)
BUT: big existing firms may not fear small new firms
Give examples of Interventionist SSPs with evaluation: (5)
- Improve standards of training and education: this makes workers more skilled = more productive, and so reduces firms costs per unit. It also reduces structural unemployment, so improving the use of factors of production
BUT: this is very difficult. People may gain qualifications in subjects which don’t improve productivity (they may have cultural rather than economic benefits) and there is a massive time lag before the benefits of improved education can be seen - Improve infrastructure: by improving transport links, communication links etc, the gov can reduce firms’ costs and increase productivity. This may be done as part of a regional policy to ‘regenerate’ certain areas
BUT: these projects are time consuming and very expensive (means higher taxes, which are a disincentive to work). In addition there is no guarantee the gov will build the right type of infrastructure business will need - Increase labour mobility: occupational - training, geographical - affordable housing, loss of pension rights - personal pensions
BUT: these measures all involve costs to the gov, which may mean higher taxes… - Helping small businesses: for example in the UK “Enterprise Finance Guarantee” (EFG) scheme aims to help SMEs (Small & Medium Enterprises) get bank loans, by the gov guaranteeing 75% of an SME’s bank loan. There are various restrictions (a max loan of €1 mil for example), but it has also helped around 6000 SMEs
BUT: there is no certainty SMEs will want to borrow. It depend on factors like confidence - Encourage banks to lend: the UK National Loan Guarantee is a policy where the gov guarantees bank borrowing, allowing banks to lend at a lower interest rate, so long as they lend out this money to SMEs as cheaper loans (1% less interest) - again there are conditions for an SME to be eligible
BUT: there is no guarantee banks will want to lend
Give examples of general evaluative points for SSP questions: (5)
- Time lag: most SSPs will take a long time before they have an impact. For example improved education will only shift AS 10 years later
- No guarantee policies will be effective: many SSPs ‘encourage’ change - but there is no guarantee it will occur. For example spending more on education (↑AS) may not improve the quality/skills of future workers
- Supply Side Conflicts: some SSPs may conflict with each other. For example more spending on education (↑AS) may mean higher taxes, which reduces incentive to work (↓AS)
- Impact on AD: many SSPs may impact AD, such as increased investment, increased gov spending, reducing tax (all ↑AD) or reducing wages/ benefits (↓AD)
- Uneven distribution of income: many claim free market SSPs are really a cover for helping the rich at the expense of the poor. There is a criticism that SSPs assume poor are motivated to work harder by taking money away from them and the rich are motivated to work harder by giving them money
Explain the Inflation vs Unemployment conflict:
- Curve
- Why
- Evaluation
The Phillips curve shows that there is a trade off between unemployment and inflation. It is based on historical data (originally ‘change in money wage’/unemployment)
Why does ↓unemployment -> ↑inflation ?
- Relative negotiating power of employees/employers. If unemployment is high, employees are in a weaker position and so unable to demand ↑wages (=low inflation)
- An increase in AD (via an expansionary fiscal policy or loose monetary policy) will ↑real output (=↓unemployment) but ↑Price Level (inflation), assuming AS is not perfectly elastic or inelastic
Is it always true that reducing unemployment will push inflation ‘above target’?
- Increase in (LR)AS: ↑AS -> ↑real Y (=↓unemployment) and ↓PL (=↓inflation)
- If a country was facing deflation (or low inflation) it may want to ↑inflation (to 2%) so there is no conflict of objectives, in ↓unemployment and ↑inflation
