Macroeconomic policies Flashcards
sources of government revenue
- taxes (direct and indirect)
- sale G&S (postal service, nationwide railway operators, etc.)
- sale of government-owned enterprises (i.e. privatisation)
types og govt. expenditure
- current expenditure (spending on G&S consumed within the year)
- capital expenditure (long-term govt. investments to increase economy’s productive capacity)
- transfer payments (welfare payments without corresponding return)
budget surplus
define
When govt. revenue is greater than govt. expenditure for the current fiscal year.
Occurs during booms when taxes are high and transfer payments are low.
budget deficit
define
When govt. revenue is less than govt. expenditure for the current fiscal year.
Occurs (usually) during a recession when taxes are low and transfer payments are high.
balanced govt. budget
define
when govt. revenue = govt. expenditure
Relationship between govt. budget and public debt
Budget deficits require govt. borrowing and hence increase “public debt”.
Budget surpluses will decrease the public debt caused by budget deficits in previous years (but can be unpopular with taxpayers).
characteristics of expansionary fiscal policy
- help close a recessionary gap by increasing AD
- lower unemployment and boost economic growth BUT may cause inflation if economy is close to or at full employment
- only advocated by Keynesian/demand-side economists (causes inflation in neoclassical)
- effectiveness is affected by value of Keynesian multiplier
characteristics of contractionary fiscal policy
- helps close an inflationary gap by decreasing AD
- lower rate of inflation but may negatively affect unemployment and slow down economic growth
- works in both models
how does each model approach increases in AD
- classical economists believe the private sector is more efficient than the government, hence demand-side policies will cause a decline in economic welfare
- monetarists believe AD is perfectly inelastic in the long run, so attempts to increase AS will simply be inflationary
automatic stabilizers
Help stabilize short-term fluctuations in economic activity.
- when an economy booms, tax revenue increases and govt. spending on unemployment benefits decreases automatically
- during recessions, tax revenue decreases and govt. spending on unemployment benefits increases automatically
how does fiscal policy affect potential output?
Govt. spending can be used to promote long-term economic growth and increase potential output.
Indirectly:
- Creating an economic environment favourable to private investment
Directly:
- govt. spending on physical and human capital
- provision of incentives for private firms to invest
pros and cons of fiscal policy
Pros:
- ability to target sectors of the economy
- direct impact on AD
- effectively promotes economic activity
Cons:
- time-lags (recognizing the probelm, putting together a plan and having the legislation approved, and the time it takes to make an impact)
- political constraints (popularity)
- crowding out
- inability to deal with supply-side causes of instability
role of the central bank
- regulator of commercial banks
- baker for the government
Central banks are usually made responsible for interest rates and exchange rates in order to achieve macroeconomic objectives.
monetary policy
define
the govt.’s use of interest rates and the supply of money to influence AD and the level of economic activity
interest rates
define
the price of borrowing money or the return from saving money at financial institutions
supply of money
define
total amount of money circulating in the economy at any point in time
How does the central bank influence the supply of money?
i.e. tools of monetary policy
Setting and changing the minimum reserve requirement:
- increase = supply of money ↓, IR↑
- decrease = supply of money ↑, IR↓
Quantitative easing (buying/selling govt. securities):
- buying = supply of money ↑, IR↓
- selling = supply of money ↓, IR↑
Changing the central bank’s minimum lending rate:
- raising it = supply of money ↓, IR↑
- lowering it = supply of money ↑, IR↓
Role of monetary policy
Contractionary:
If IR↑, borrowing becomes more expensive and saving becomes more appealing, hence AD↓
Expansionary:
If IR↓, borrowing becomes more expensive and saving becomes more appealing, hence AD↑
inflation targeting
define
in certain countries, central banks focus just on inflation and are guided by the objective to achieve an explicit or implicit inflation rate target
RATHER THAN
focusing on the maintenance of both full employment and low inflation rate
strengths and limitations of monetary policy
Strengths:
- short time lags
- incremental and flexible
- reversible (expansionary can quickly be turned into contractionary and vice versa)
Limitations:
- as interest rates apprach 0, they cannot fall further, limiting the scope/effectiveness for large recessionary gaps
- may become inflationary if it lasts too long (AD increases beyond necessary)
- low business and consumer confidence (if expectations about the future are pessimistic, consumers and producers won’t increase consumption/investment)
supply-side policies aim to positively affect the production of the economy by:
- improving the institutional framework
- improving the economy’s productive capacity
i.e. changing the quantity and/or quality of the FOP
what do supply-side policies aim to do?
shift the LRAS curve to the right and achieve growth in potential output
interventionist supply-side policies
define
deliberate attempts by the govt. to connect market failures in the economy and increase the productive capacity of the economy
types of interventionist supply-side policies
- investment in human capital
- investment in new technology
- investment in infrastructure
- industrial policies
all will increase AD in the short run and increase LRAS in the long run
how does investment in human capital work to increase LRAS
(interventionist supply-side policy)
- investment in education and training will raise level of human capital
- more productive workforce
- increase in productive capacity of economy
how does investment in new technology work to increase LRAS
(interventionist supply-side policy)
- policies that encourage R&D
- new technologies / increased efficiency
- increase in productive capacity of economy
how does investment in infrastructure work to increase LRAS
(interventionist supply-side policy)
- increased and improved infrastructure (e.g. better roads, canals, highways, airports, ports electricity, communication networks)
- increase in productive capacity of economy and increased efficiency
how do industrial policies work to increase LRAS
(interventionist supply-side policy)
- targeting specific industries through policies like tax cuts, tax allowances, subsidized lending
- promotes growth in key areas of the economy
- increase in productive potential of the economy
market-based supply-side policies
define
focus on allowing the free market to operate with minimal govt. intervention by improving market incentives to increase investment and productivity
types of market-based supply-side policies
and examples of each
Policies to encourage competition:
- deregulation
- privatisation
- anti-monopoly regulation
- trade liberalisation
Labour market reforms:
- reducing power of trade unions
- reducing unemployment benefits
- lowering/abolishing minimum wages
Incentive-related policies:
- personal income tax cuts are used to increase incentive to work
- cuts in business tax and capital gains tax are used to increase incentive to invest
how do policies to encourage competition work to increase LRAS
(a type of market-based supply-side policy)
all aimed at encouraging competition and hence increasing the productive capacity of industries and the economy
how do labour market reforms work to increase LRAS
(a type of market-based supply-side policy)
they make the labour market more flexible and more responsive to demand and supply
HOWEVER: while they do make the labour market more efficient, it comes at the expense of equity
how do incentive-related policies work to increase LRAS
(a type of market-based supply-side policy)
- more labour market productivity
- increased investment
evaluation of supply-side policies with respect to time-lags
BOTH:
benefits reaped only in the long run
evaluation of supply-side policies with respect to ability to create employment
INTERVENTIONIST:
create employment in short-run and long-run
MARKET-BASED:
may create employment in the short-run, but create employment in long-run
evaluation of supply-side policies with respect to ability to reduce inflationary pressure
INTERVENTIONIST:
may be inflationary in the short-run due to increased AD, but will reduce inflationary pressure in the long run when LRADS and SRAS increase
MARKET-BASED:
may or may not reduce inflationary pressure in the short-run (depending on the policy), but will reduce inflationary pressure in the long-run
evaluation of supply-side policies with respect to impact on economic growth
INTERVENTIONIST:
create both short-run and long-run economic growth (AD↑ and LRAS↑)
MARKET-BASED:
effect on short-run economic growth depends on policy, but definitely causes long-run economic growth (LRAS↑)
evaluation of supply-side policies with respect to impact on govt. budget
INTERVENTIONIST:
cost a lot of money (drain govt. budget) in the short run
MARKET-BASED:
reduce sources of govt. revenue in the short-run (e.g. cuts in taxes, deregulation, trade liberalization, etc.)
evaluation of supply-side policies with respect to effect on equity
- some supply-side policies improve the distribution of income by lowering the NRU
- some supply-side policies involve a trade-off between efficiency and equity (e.g. labour market reforms improve efficiency at the expense of equity)
evaluation of supply-side policies with respect to effect on the environment
BOTH:
supply-side policies are aimed at growing the productive capacity and potential output of the economy, which can lead to overuse of natural resources and unsustainable consumption patterns
real vs nominal interest rates
The nominal interest rate is the interest rate quoted by commercial banks. If you borrow $100 at a 9% interest rate, you will pay $9 in interest. However, the nominal interest rate is not adjusted for inflation.
A real interest rate is the interest rate with inflation taken into account. It indicates the true cost of borrowing money. Imagine a bank lends someone $100 at a nominal interest rate of 3%. Let’s assume that the inflation rate is 2%. The real interest rate the borrower is paying is only 1%.
goals of fiscal policy
- Low and stable inflation
- Low unemployment
- Promote a stable economic environment for long-term growth
- Reduce business cycle fluctuations
- Equitable distribution of income
- External balance
what is crowding out?
When increased public sector (govt.) borrowing and spending leads to a decrease in loanable funds and an increase in interest rates. This can lead to lower private investment in the economy.
goals of supply-side policies
- Long-term growth by increasing the economy’s productive capacity
- Improving competition and efficiency
- Reducing labour costs and unemployment through labour market flexibility
- Reducing inflation to improve international competitiveness
- Increasing firms’ incentives to invest in innovation by reducing costs
