Policy Flashcards
NOTE
To achieve the macroeconomic objectives
What must the situation be at the start of the scenario?
What objective am I trying to achieve?
For impacts, look at AD
Reducing interest rates
Increasing the money supply (which leads to a fall in the interest rate)
Analysis: A fall in interest rates means that the cost of borrowing and the reward for saving is less. So, households and firms are more incentivised to take out loans (as they are cheaper), and less incentivised to save, leading to an increase in consumption and investment. This therefore leads to an increase in AD (AD-AD1), leading to an increase in the price level (P-P1) and Real GDP (Y-Y1).
Increasing interest rates
Decreasing the money supply (which ultimately leads to an increase in the interest rate)
Analysis: An increase in interest rates means that the cost of borrowing and the reward for saving is more. This means that households are less incentives to take out loans (as they are more expensive), and more incentivised to save (as there is a greater reward for doing so), leading to an decrease in consumption. This therefore leads to a decrease in AD (AD-AD1), leading to a decrease in the price level (P-P1) and Real GDP (Y-Y1).
Demand-side (AD)
Monetary (interest rates, money supply), fiscal (govt spending, taxation)
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 (exports vs imports)
Govt revenue
indirect taxes (on goods and services, included in the selling price, paid via firms to tax authorities) e.g sales tax, excise duties, stamp duty, carbon tax
direct taxes (e.g. on income and wealth) e.g income tax, corporation tax, capital gains tax, inheritance tax, windfall tax
sale of goods and services (e.g. oil sold by state firms)
sale of state-owned firms (e.g. electricity, railway or water company)
Govt expenditures
current expenditures - for immediate operations and benefits to satisfy the needs of individuals or groups in society, e.g. wages/ salaries of public sector employees, hospital supplies, interest repayments
capital expenditures - money spent increasing the nation’s capital stock, e.g. new roads, airports, schools, hospitals
transfer payments - no exchange of goods and services, used to redistribute income, e.g. unemployment benefits, state pensions, housing benefit, child benefit, disability benefit
Govt budget
Revenues > Expenditures = budget surplus, a fall in public debt
Expenditures > Revenues = budget deficit, increase in public debt
Expenditures = Revenues = balanced budget, no change in public debt
Note that when the public debt is lower, the interest payments on the debt will also be lower. This will make it easier for a government to have a balanced budget.
Fiscal policy evaluation
Strengths:
The ability for a government to promote economic activity during a deep recession or time of specific need
The ability to target specific sectors
Redistribution of income and equity
Achieving macroeconomic objectives
Automatic stabilizers (HL)
The multiplier effect (HL)
Weaknesses:
Political pressures - getting agreement on details of the policy
Time-lags - the time it takes to recognise that intervention is needed, the time it takes to complete the administration involved in order to implement/ roll-out the policy, the time it takes for the policy to have an impact/ see a change
Conflicting objectives/ unintended consequences e.g raising taxes can affect incentives to work, economic growth may conflict with inflation
Assumes efficiency and competency from a government
Opportunity cost - spending on this versus other priorities
Sustainable debt the extent to which a government can afford to sustain a budget deficit. Also, the interest cost impacts future spending.
Crowding out (HL)
Fiscal policy impacts
DIRECT taxes
What are the impacts?
Government spending (G)
Pretty simple - it directly impacts AD
Monetary policy impacts
A demand-side policy using changes in the money supply or interest rates to achieve economic objectives relating to output, employment and inflation. The mechanism is to increase AD through increases in C and I.
Monetary policies are implemented by the central bank of a country.
- easy monetary policy - expansionary to close recessionary gap
- tight monetary policy - contractionary to close inflationary gap
Central bank
Responsibilities
Conduct monetary policy: establish interest rates and money supply
Can impact exchange rates (more next year!)
Focused primarily on inflation, then on economic growth
The banker to the federal government, the banker to the commercial banks, regulator of commercial banks
Typically some independence from political control, but still considered part of the government
Monetary policy goals
The maintenance of a low and stable rate of inflation, usually tied in with ‘inflation targeting’ where the central bank sets a specific medium-term inflation rate as a goal
A low unemployment rate
A stable economic environment for long-term growth
Reduce fluctuations in the business cycle
Achieve an external balance between export revenue and import expenditure
Interest rates
The cost of borrowing money or the reward for saving money over a period of time expressed as a percentage. We treat these as one but, in reality, they are not.
There are lots of different terms for different interest rates, but we will discuss them generically as the rate that is set by a country’s central bank.
The central bank is essentially the government’s bank and ultimate authority in control of the money supply in an economy. In some countries the government controls the central bank, but in most industrialized countries the central bank is an independent body with the primary responsibility of deciding monetary policy.
Ratchet
The ratchet effect is related to the core idea of Keynesian theory; when AD goes up, prices will go up, but when AD goes down, wages and prices are “sticky”. So here you have a decrease in AD, but the price level stays at PL1 instead of going down to Pl2 at the intersection of AD2 and the Keynesian AS.
Monetary policy evaluations
Strengths:
It is relatively quick to put into place - (the central bank can usually change the interest rate each month if they wish, or faster if really needed)
There is limited political intervention - when a central bank is independent of the government they can make politically unpopular decisions and do not have to go through a political process to change them
An absence of “crowding out” - HL concept
The ability to make small changes - interest rates can be changed by a quarter of a percent which allows more fine-tuning of an economy
It does not cost the government money to implement
Weaknesses:
Time lags- even though interest rates can be changed quickly it takes time for them to have an effect. Some sources state that it takes an estimated 12-18 months to see a change in AD from a change in interest rates
Ineffectiveness when interest rates are low- as interest rates become very low and approach zero they become ineffective as a policy tool as they can no longer be lowered any further
Low consumer and business confidence - if consumer and business confidence is low due to a recession for example, the lowering of interest rates may have little effect
Dependent on ease of borrowing- even in interest rates are low, if banks are unwilling to lend and/or make it difficult to borrow, there will be a limited effect on AD
