Macroeconomic Objectives And Policies Flashcards
What are the seven main objectives that governments generally wish to pursue
Economic growth (rises in real GDP) Reduction in unemployment Control of inflation Equilibrium in the balance of payments on the current account Balanced government budget Protection of the environment More equal distribution of income
What are the order of priorities of macro objectives
It varies according to the politics of the government in office at the time and the particular economic circumstances in the country.
Priorities are also influenced by factors such as inflation targets which independent central banks are required to meet. Some governments see the control of inflation as the most important macro goal. Others, such as governments with a socialist leaning, focus on the redistribution of income and the reduction of unemployment.
What are the 2 demand side policies
Demand side policy is a deliberate manipulation by the government of AD in order to achieve macroeconomic objectives
They are fiscal policy and monetary policy
What is fiscal policy briefly
Fiscal policy is the governments management of its spending and taxation with the aim of changing total level of spending in the economy
What is monetary policy briefly
Monetary policy is decision making using monetary instruments such as the interest rate or quantitative easing.
What’s the primary objective of monetary policy
Meet the governments 2% inflation target
Who sets the base interest rate each month
The Bank of England’s Monetary Policy Committee (MPC)
What are the two major tools available to the MPC
The first is changing is changing the base rate of interest - the bank rate which is set by the MPC and is a bench mark for other interest rates in the money market.
The second is quantitative easing, which can be used as well as the manipulation of the base interest rate.
What are monetary transmissions mechanisms
Changing the rate of interest sets off a chain of reactions in the economy, many of which mean that AD will shift. We call these processes monetary ‘transmissions mechanisms’. This means that there are processes which, step by step, mean that an interest rate transmits change in demand.
How do the monetary transmissions mechanisms work with interest rates to change consumption
These mechanisms work through consumption, for example by affecting how much money people have after paying their mortgage. Also, consumers spend different amounts depending on the cost of credit and the amount they receive for their savings.
How do the monetary transmissions mechanisms work with interest rates to change investment
Investment is sensitive to interest rate changes: higher rates mean that fewer projects are deemed to be worthwhile.
How do the monetary transmissions mechanisms work with interest rates to change net exports
Net exports are affected by interest rates for two reasons. First, interest rates affect costs of production and therefore relative productivity. Second, interest rate changes are likely to affect exchange rates, which have an impact on export and import prices.
When interest rates are raised, how does this affect consumers borrowing
When interest rates are raised, the cost of borrowing rises. Consumers who borrow in order to finance their spending might be deferred from doing so and savers will be less keen to spend their savings because their is a greater opportunity cost in doing so.
When interest rates are raised, how does this affect consumers with mortgages
People with mortgages - of whom there are almost 10 million in the uk - will find their mortgage interest repayments rise and will therefore be discouraged from spending, although those with fixed rate mortgages will not suffer this immediately.
When interest rates are raised, how does this affect consumers hire purchase
Hire purchase - the method of buying major durable items, such as cars and white goods, on credit- will incur increasingly expensive monthly repayments instalments, which means that consumers might delay further major expenditures.
When interest rates are raised, how does this affect consumers house prices and wealth effects
House prices might fall as mortgages become less affordable. This can cause negative wealth effects, where lower asset prices mean that people feel less inclined to spend and less able to take out loans based on the equity of their homes.
How will increased interest rates affect firms
Firms will find that investment is less attractive in many cases and that fewer investments will make a return higher than the increased cost of borrowing. Therefore, firms will be less inclined to invest, which not only reduced current AD but also has implications for long term output prospects. The price of exports might increase because interest rates are essentially a cost of production, so exports will fall and imports will rise. This is made even more likely when we factor in a probable increase in the exchange rate, which occurs when ‘hot money’ is attracted by higher interest rates in the UK.
Increasing interest rates is likely to..
Decrease consumption, investment and reduce exports, increase imports.
Thus, all these changes shift the AD curve to the left. Decreases in investment and exports would cause downward multiplier effects on GDP. Depending on the shape of the AS curve, this may decrease both the price level and real output. Increasing interest rates can be an effective way of controlling inflation, but the cost is that economic growth is likely to fall.
Define negative wealth effect
A reduction in wealth, which results in a reduction in consumption and, therefore, a reduction in production and employment.
Tell me a dramatic example of the use of interest rate policy
It occurred in the latter part of 2008 and during 2009 as the global financial crises gathered pace. Spending in the economy slowed sharply. This threatened a downward spiral through a combination of contracting real output and price deflation.
The MPC responded decisively, cutting the Bank Rate from 5% to 0.5% - its lowest ever level - in just 5 months to reduce the risk of inflation falling below the 2% target.
The cut in interest rates was designed to stimulate aggregate demand and increase real national output.
When you consider a rise in interest rates, what usually happens to the value of the exchange rate
The value of the exchange rate is likely to change in the same direction. For example, if interest rates rise, the exchange rate of the pound is likely to rise. With a strong pound imports are cheap and exports are dear, which is remembered by the acronym SPICED.
Define quantitative easing (QE)
The purchase of gilts and other illiquid assets as a means of making credit easier to access.
Tell me some background info on quantitative easing (asset purchases by the central bank)
The MPC announced in March 2009 that it would start to inject money directly into the economy to boost spending - a policy known as quantitative easing (QE). It began purchasing financial assets (long term loans called gilts), funded by the creation of central bank reserves which are paid for by selling Treasury bills (short term 90 day loans), which are effectively cash as they are so easily turned into cash. It is what the media call ‘printing money’, but it is more honest and fair than that term implies. The banks asset purchases are designed to inject money directly into the economy to raise asset prices, boost spending and so keep inflation on track to meet the 2% target.
QE was needed in 2009 to reduce the impact of the global financial crisis. Bond purchases started at £200 billion in 2009. Further rounds have resulted in the building up of these bond purchases to £435 billion in 2016.
Explain how QE works
The central bank ( in the UKs case, the Bank of England) makes large purchases of government bonds. This pushes up their price and lowers the interest rate (yields) on these bonds. The lower interest rates feed through the economy so reducing the cost of borrowing by firms and households. In turn, this will cause an increase in consumption and investment.
In addition, QE is likely to cause a rise in asset prices (shares, houses). Consequently, there will be a wealth effect which will cause an increase in consumer spending so boosting aggregate demand.
What factors may dampen the effects of QE
One is the nature of the banking sector. For example, after the global financial crisis, banks were concerned about their financial health and as a result were less willing to lend. For this reason, the MPC did not expect QE to result in a material expansion of bank lending. Furthermore, if the confidence of consumers and businesses is low, then they will be unwilling to borrow despite the willingness of banks to lend.
When will quantitative tightening be used
As economic recovery becomes stronger and more sustained, the monetary policy measures required to deliver the inflation target will need to be changed. This means that, at some point, the Bank of England will tighten monetary policy by reselling asset purchases to the money markets. This process of reselling assets to the money markets is referred to as quantitative tightening, because the availability of credit will be reduced.
Define quantitative tightening (QT)
A contractionary monetary policy applied by the central bank to decrease the amount of liquidity within the economy. One way of achieving this is by letting the central banks bond holdings mature each month without replacing them.
What are the fiscal policy instruments
Fiscal policy is the manipulation of taxes and government spending to influence the overall level of demand in an economy.
What does expansionary fiscal policy mean
Cutting taxes (T) or raising government spending (G) or a combination of the two, so that AD rises
What does contractionary fiscal policy involve
Increasing taxes and/or reducing government expenditure, causing a fall in AD
What’s the net effect when government spending is greater than taxation
The government is operating a budget (or fiscal) deficit. The net effect is to pump spending power into the economy. This is referred to as expansionary or reflationary fiscal policy.
How does the multiplier magnify the effects of expansionary fiscal policy
The multiplier magnifies the effect of this boost in AD. For example, if the government builds a new hospital and does not pay for it through current taxation but instead borrows to finance the scheme, there will effectively be more spending power in the economy. When the government pays for the workers and building materials for this hospital, the incomes will be re spent in the economy, creating new incomes - which is the multiplier in operation. If an economy is going through a slowdown or recession then, according to Keynesian thinking, the government should spend its way out of recession.
What’s the net effect when government spending is less than taxation
There is said to be a budget (or fiscal) surplus, which takes spending power out of the economy with negative multiplier effects. The consensus among economists is that in times of boom or fast growth in the economy, the government should rein in its spending to curb inflationary pressures. This is known as contractionary or deflationary fiscal policy.
What are the two types of tax changes the government can use in fiscal policy
Governments can change fiscal policy by changing its tax or spending levels, or both, within the tax changes it can change direct tax, which is tax on incomes (eg income tax and corporation tax), or indirect tax, which is tax on spending (eg VAT)
How will changing direct tax affect AD through fiscal policy
A direct tax will have a direct impact on AD because people feel better or worse off according to how much their income changes. We make spending plans based on our disposable income, ie income after tax. Although the changes in direct tax might not have an immediate effect, there is the compounded effect of expectations and confidence. If direct taxes are raised then disposable income is likely to fall causing a decrease in consumption and, therefore, a decrease in AD.
How will a change in an indirect tax in fiscal policy cause an effect
An indirect tax has a more obvious effect on AS because it affects the amount that firms are willing to sell at any particular price. Many firms have to absorb some of the effects of a rise in VAT, for example, so will be less willing to sell when VAT is raised. We show this by a short run upwards shift in the AS curve.
You need to remember direct taxes can shift AD and indirect taxes tend to shift AS
Define direct taxes
Taxes paid directly to the government by the tax payer. They are usually imposed on income or wealth.
Define indirect taxes
Taxes that taxpayer can pass on to someone else (eg the consumer). they are usually taxes on expenditure.
What are the main purposes of the MPC
Achieve the governments target for inflation.
However, in its remit to the MPC in 2018 it is stated that the objectives of the Bank of England shall be:
Maintain price stability
Support the economic policy of her majesty’s government, including its objectives for growth and employment.
Tell me about the role and operation of the Bank of England’s MPC
The manipulation of monetary variables such as the interest rate has enormous implications across the whole economy. In the UK a group of up to 9 economists from the MPC, whose primary purpose is to control inflation. They meet at least once a month for a day and a half to examine evidence from across the country relating to inflationary pressures.
They have a target for CPI inflation set for them by the chancellor of the exchequer, currently at 2%. If inflation falls outside the range of 1-3%, the governor of the Bank of England must write an open letter to the chancellor of the exchequer to explain why this has happened. In its first 10 years of operation, this occurred only once when inflation reached 3.1% in March 2007, but between 2008 and 2011 he had to write 10 such letters (he only has to write one every 3 months if inflation remains above the ceiling). Between 2011 and 2018 the governor has had much less explaining to do although the inflation rate did fall below 1% in 2015. And the first part of 2016.
Tell me how demand side policies were used in the Great Depression
The Wall Street Crash of 1929 triggered a worldwide crash in stock markets and a global recession, much like the 2008 experience. Back in 1929 Keynes was influential in terms of policy responses both in the USA and UK. Expansionary fiscal policy was used to bring back some confidence in markets and stop the spiral downwards of demand and output. The uk did not respond as quickly as the USA, and it was not until the post war period, under a labour government elected in 1945, that demand side policies became significantly expansionary.
By 1968, however, Keynes ideas had become discredited. These demand side policies resulted in inflation, which led the government to adopt contractionary policies. During the 1970s, partly as a result of these policies and also because of an increase in oil prices, the UK experienced both inflation and unemployment at the same time.
Stagflation was the term used to describe this situation of persistent unemployment, slow or zero economic growth and high inflation. Milton Friedman in Chicago wrote that expansionary fiscal policy would only cause inflation and the effect on the jobs market would only be short term. He concluded that governments should not use demand side policies at all to influence the level of output and unemployment. Friedman’s ideas were popular on both sides of the Atlantic up until 2008
Define stagflation
Situation where the economy is stagnant (not growing) and is also suffering from inflation.
What were the demand side policy responses like in the 2008 crisis
The policy responses post the 2008 crisis were broadly similar in the USA and the UK until 2010. In the USA president Obama was clearly a Keynesian, using fiscal policy to expand the economy by increasing government expenditure on major infrastructure projects across the country. In the UK the labour government under Gordon brown was similarly seen to increase spending and cut taxes (eg VAT was temporarily reduced), and the budget deficit rose from about £40 billion in 2007-8 to over £150 billion in 2008-9. However, everything changed in 2010 when the Labour Party lost the general election and the new coalition government made the fiscal balance one of its main objectives. Since then the UKs economic growth has been subdued and below its previous long term trend.
Evaluate monetary policy to do with time lag/time scales
Monetary policy has a shorter late time than fiscal policy, although the MPC estimates that interest rate changes can take between 18 months and 2 years to have their full impact. There are further time delays because many mortgage holders have fixed rate contracts, which may delay the impact on their spending for some years. Furthermore, Monetary is a blunt tool that hits the whole economy, affecting both small and large firms, and rises in interest rates usually worsen income distribution.
