policy instruments Flashcards
what is fiscal policy?
refers to changes in taxation and government spending in order to influence AD in an economy
what is demand side fiscal policy? (2)
attempts to influence AD, the aim could be:
- stimulate economic growth in a period of recession
- maintain low inflation
what is supply side fiscal policy?
give an example
-supply side fiscal policy attempts to influence productivity and the supply side of the economy
- spending on education to improve labour productivity
what is expansionary fiscal policy? (2)
- changes in G and T that aims to boost AD
- it will increase the size of the budget deficit and may cause inflation
why do governments use expansionary fiscal policy? (4)
- reduce unemployment (more g&s)
- increase economic growth (e.g. in a recessions )
- reduce income inequality (e.g gov spending on welfare benefits )
- leads to multiplier effect - higher incomes in economy, higher spending, more AD and so on
list expansionary fiscal policy examples (3)
- reduction in income tax , for those in lower tax brackets, increasing disposable income, increasing marginal propensity to spend
-reduction in corporation tax, (tax on business profit) increasing retained profits, increasing marginal propensity to invest
-increase in government spending on healthcare, infrastructure, public sector wages ect
what is the positive side effects of expansionary fiscal policy (3)
• increases the productive potential of the economy
-reduction in income tax boosts the incentive to work increasing the quantity of labour there’s also a greater incentive to work harder
-reduction of corporation boosts investment and improves the quantity and quality of capital, improving productive efficiency
- increase in gov spending increases productivity of labour
what is deflationary/ contractionary fiscal policy
involves changes in to government spending and taxes with the aim to reduce AD
why is contractionary fiscal policy used? (4)
- cool the economy down ( high rates of demand pull inflation (in theory)
- reduce budget deficit, by reducing borrowing and the overall level of debt
- redistribute income e.g higher taxation on the rich
- reduce current account deficit, if AD is reduced, incomes will be lower less imports consumed
what are the implications of fiscal policy?
(6)
- poor information- may reduce the accuracy of forecasting future economic growth and inflation. so gov is unsure with to boost or reduce AD
- depends on other components of AD - for example, if government cuts income tax to increase AD, it would be ineffective if consumer confidence is low so people just save extra income
3, disincentives to work- higher income tax to reduce inflation create disincentives to work reducing productivity and AS
- time lag - there will be delays in committing to more government spending and delays in it effecting wider economy
- Budget deficit- Expansionary fiscal policy will increase government borrowing. this could lead to higher interest rates in long term or cause markets to lose confidence in debt levels
- crowding out- if the government spend more by borrowing from private sector, it may reduce the amount of money the private sector has to spend
what is the national debt?
public sector net debt is the cumulative amount of debt that the government owes the private sector
explain the trend of national debt in the UK over the years
- national debt as a percentage of GDP peaked after the first and second world war
- it fell during the post war period as economic growth led to higher GDP
- Net debt has increased since the financial crises of 2007
1.what is the definition of the budget deficit
- how do we calculate budget deficit?
- how do we measure budget deficit?
- what can the budget deficit also be referred to as?
- the annual amount the government needs to borrow from the private sector
- difference between government spending and tax revenue
- measured through stats such as public sector net cash requirement and net borrowing
- net borrowing
- what are the 3 main types of government spending?
- what is real government spending?
- capital expenditure
current expenditure
transfer payments - spending levels adjusted for inflation
what is capital expenditure?
(4)
- spending on capital projects and creating new assets
- increases capital stock if economy
- typically involves building new roads, hospitals and communications
- shifts LRAS to right
what is current expenditure
-gov spending on items that are recurring and only lasts a limited time
- e.g. spending on public sector wages and consumable products
what is transfer payments?
(4)
-simple payments from the government to individuals
- represents a redistribution of income in society
- e.g. welfare payments like unemployment and housing benefit
- risks creating disincentives to work
what could higher gov spending imply?
- more investment into education and infrastructure - provides goods with positive externalities, and greater social efficiency
- redistribution - promotes an equal society and improve economic welfare. countries like UK, France and Norway have the most developed welfare states
- Fiscal policy - stimulates economy in recession. e.g gov borrowing can offset a rise in private sector saving and increase AD
- automatic stabilisers - between 2007 and 2010 there was an increase in gov spending as a % of GDP because of the recession. there was higher spending on unemployment and housing benefits
what are the implications of government spending? (5)
- higher taxes may be required to fund higher spending - higher income tax creates disincentives to work and higher corporation tax discourages firms from setting up
- inefficiency of government spending- government bodies lack a profit incentive so government spending could be wasteful
- efficiency - government spending could be more efficient through competitive tendering and public private partnerships
- crowding out - increase in the government sector has an opportunity cost. more gov spending means a decline in the size of private sector and a reduction in private sector enterprise
- Depends on the kind of spending
what are the main types of taxation
(5)
-Direct taxation
-indirect taxation
- progressive tax
- regressive tax
-indirect taxation
- what is progressive tax?
- explain how progressive tax works 3.give an example
- as income rises, the average rate of tax goes up
- as people earn more money they end up in a higher tax band where tax rates are higher
- the amount of tax paid as a proportion of their income goes up
progressive income tax
- what is proportional tax?
- give an example
- as income rises, the rate of income tax stays the same
- e.g. flat income tax
- what is regressive tax?
- give an example
- as income rises the average rate of tax as a proportion of income falls
- indirect tax
- what is direct taxation?
- give an example
- taxes taken directly from a persons wage
- income, NI contribution
- what is indirect taxations?
- give examples
- what is the VAT rate?
- taxes paid by firms selling goods. The firm has to pay the VAT rate to the government consumers pay these taxes indirectly when a good in bought
- VAT, excise duty (alcohol, tobacco) and petrol tax
- 20%
what are the 3 highest tax revenues?
- income tax
- national insurance contribution
- VAT tax
what are the 4 reasons for taxation revenues decreasing beyond the efficient tax rate?
• disincentives to work
• emigration
• tax evasion (not claiming all income)
• tax avoidance (finding loop holes in the tax system)
- what is the average rate of tax?
- what is the equation for art?
1.the amount of tax paid as a proportion of income
- (tax paid/ income) X 100
what are the benefits of higher tax revenues? (2)
- the government can spend more on public services and benefits to reduce inequality and fund capital investment
- higher rates of income tax help to redistribute income for higher earners to low earners creating more equality
what are supply side policies?
- policies designed to increase the productive capacity of the economy
- shifting LRAS to the right
what happens if supply side policies are successful?
all four macroeconomic objectives will improve
give examples of the positives of supply side policies (4)
- reduction of unemployment by reducing structural, frictional and wage unemployment
- reductions in long term rates of inflation
- improves economic growth (by increasing AS )
- improves trade and balance of payments ( making firms more competitive, they will help able to export more)
- what are interventionist supply side policies?
- what are market orientated supply side policies?
- involves government spending to overcome market failure
- policies to reduce regulation and allow free markets to function more efficiently
why will LRAS shift to the right with supply side policies? (3)
- increase in the quantity of factors of production
- increase in quality of factors of production
- increase in the productive efficiency in economy ( reduction in long run costs of production for businesses)
what are the examples of interventionist supply side policies?
(4)
- increased gov spending on education and training
- improving transport and infrastructure
- providing better information about available jobs
- subsidies to firms to promote investment
- how can increased spending on education and training work as a supply side policy?
- give 2 examples
- what are the 2 disadvantages?
- better education improves labour productivity, improving to quality of the factors of production
- subsidising suitable training schemes in free markets
- build new schools
- educational policies can take several years to come into effect
- may not have the staff
- how can gov spending on infrastructure work as a supply side policy
- give 3 examples
- what are the 4 disadvantages?
- long run costs of production for businesses will fall because it’s easier and cheaper to access raw materials and easier and cheaper to sell g&s. productive efficiency in economy will rise
- new schools and hospitals increases the capital stock of the economy
- long run costs of production for businesses will fall because it’s easier and cheaper to access raw materials and easier and cheaper to sell g&s. productive efficiency in economy will rise
- new transport infrastructure being built
- existing transport infrastructure being upgraded ( roads, ports, railways, HS2, Heathrow )
- new schools and hospitals
- can take a long time especially in UK
- can be expensive
- may not have workers
- environmentally unsustainable
- how can subsidies to firms promote investment work as a supply side policy?
- give examples (2)
- what are the disadvantages (2)
- investment increases the quantity and quality of capital and reduces long run costs of production for businesses
- upgrading capital like new tech
- factory expansion
- funding subsidies can create pressure on government budgets leading to cuts in other essential services or investments
- funds could be better spent on other initiatives
- funding subsidies can create pressure on government budgets leading to cuts in other essential services or investments
what are the market based supply side policies ?
- tax reform
- labour market reform
- competition policy
- how do competition policies work?
- boosts competition across the economy, then firms have to reduce their long run costs of production to be competitive and survive in competitive markets, improving productive efficiency
- how does lower income tax work as a supply side policy?
- what are the disadvantages (2)
- • incentive for the inactive to enter the labour force increasing quantity of labour
• those in work have an incentive to work harder to earn more income because they can keep more of that income as disposable, improving quality of labour - income tax cuts can lead to income inequality, leaving those on lower incomes with less benefits
- reduced government revenues, less money spent elsewhere like infrastructure structure can lead to budget deficit
- how does lower corporation tax work as a supply side policy,
- what are the disadvantages (2)
- • firms have more retained profits, some profits can be used for investment purposes increasing quantity quality and productive efficiency of capital
- may disproportionately benefit the wealthy and large businesses, potentially widening income inequality gap
- decrease in tax revenues that could’ve been spent elsewhere in funding for essential public services
- how does a reduction in unemployment benefits work as a supply side benefit?
- what are the disadvantages?
- • very strong incentive for economically inactive to enter labour force in order to find work, increasing quantity of labour boosting LRAS
- lower rates of unemployment can lead to high inflation because of cost plus inflation
- there will be a point where the additional job added does not create enough productivity to cover costs
- how does the reduction in minimum wage and TU power work as a supply side policy?
- what are the disadvantages (2)
- reduction in minimum wage and trade union power will reduce long run costs of of production for businesses boosting productive efficiency thus LRAS
- lowering minimum wage can push workers below poverty line, making it difficult to meet basic living expenses and increased reliance on social welfare programs
- weaning TU power can decrease morale and lower job satisfaction
- how can deregulating labour markets work as a supply side policy?
- what are the disadvantages?
- Deregulating labour markets increases labour market flexibility and encourages firms to hire workers
- job insecurity, reduced workers rights
- how does privatisation work as a supply side policy?
- give an example
- what are the disadvantages (2)
- • selling state owned assets to the private sector as it is argued that the private sector is more efficient at running businesses as they have a profit motive to reduce costs and develop better services
- royal mail 2006, electricity sector
- since many businesses are only interested in profit they may cut services if they are not making profit
- can lead to increased costs for consumers
- how does deregulation work as a supply side policy?
- give 2 examples
- what are the disadvantages?
- • reduces barriers to entry in order to make market more
competitive,creating incentives to reduce prices and costs and opening monopolies to comp - busses, banking (monzo starling)
- if private businesses are not making a profit they will leave the market
- in financial markets deregulation can lead to excessive risk taking, contributing to financial crisis, as seen in 2008
- how can removing unnecessary red tape work as a supply side policy
- give examples
- what are the disadvantages
- makes it easier to build more factories and houses by reducing paper work. encouraging more firms to enter the market
- reforms in planning regulations
- possible environmental issues
- poor quality projects may not be fit for purpose like abandoned factories
- possible environmental issues
- how can encouraging immigration work as a supply side policy?
- what are the disadvantages?
- improves the labour supply as more workers available, some workers from other countries specialise in certain trades
- people think it lowers wage rates, people in the UK may not be willing to work for this rate
- can be controversial as immigrants are “stealing jobs”
- people think it lowers wage rates, people in the UK may not be willing to work for this rate
what is monetary policy?
involves changing the interest rate or manipulation of the money supply by the monetary authorities in order to influence AD
what are the 3 aims of monetary policy?
- control the rate of inflation with a target of 2%
- maintain sustainable economic growth
- influence the exchange rate
How does the MPC work?
- meet monthly to decide future interest rates
- if they feel the inflation rate is likely to go above the target of 2% then they will increase interest rates to moderate demand and keep inflation low
- if they feel inflation is likely to fall below the target and there’s slow economic growth they are likely to decrease interest rates to boost growth and prevent unemployment
what will the MPC look at to determine future inflation?
- rate of economic growth compared to the long run trend rate, if growth is faster than the trend rate, inflation is likely to occur
- wage growth, higher wage growth can cause both cost plus and demand pull inflation
- both unemployment meant which is likely to reduce wage inflation so the MPC is more likely to cut interest rates to boost AD
what is the role of the central bank? (3)
- monetary policy
- banker to the government
- lender of last resort ( for gov and private banks
what is the base rate?
the interest rate that a central bank will charge commercial banks for loans
what impact does a change in interest rates have on consumption? (3)
- if rates are low savers will get less return on their savings and borrowers will find it cheaper to borrow
- if rates are high borrowing is more expensive so people spend less on credit reducing consumer spending, and people are more likely to save
- higher interest rates also means that the cost of mortgages increases , therefore people have less confidence and less disposable income causing a fall in consumption
what impact does a change in interest rates have on investments?
- lower interest rates means that it is cheaper for firms to borrow money resulting in investments increasing
- higher interest rates means that it is more expensive for firms to borrow money so they will be less willing to invest
what effect do interest rates have in government spending?
-higher interest rates increase the costs of government interest payments
- this could lead to higher future taxes
what effect does interest rates have on net exports
-higher interest rates makes it more attractive to save in uk banks
- increasing the demand for the british pound and increases the exchange rate
- a higher exchange rate will reduce demand for (X-M) because exports are more expensive and imports are cheaper
how can we evaluate monetary policy?
(4)
- doesn’t impact people equally ( e.g. young people will be unhappy as they can’t afford first homes if rates are higher, pensioners who save will be happy)
- time lags- can take up to 18 months
for example higher interest rates may not reduce investment in short term because firms will continue with current investment projects - MPC sets interest rates for the whole of the UK but different regions are growing at different rates e.g. if wales was depressed high interest rates would be damaging
- depends on the situation of the economy - if economy is close to full employment a cut in interest rates is likely to CAUSE significant inflation
what other responsibilities are there for the bank of England? (4)
- issue bank notes
- carry out stress testing ( see if banks could cope with financial crash )
- hold uk gold 400000 bars
- quantitative easing
what is inflation?
the rate of increases in prices for g&s
why is inflation important?
- influences interest rate we get on savings and the rate we pay on mortgages
- inflation affects the level of pensions and benefits
- effects price of train tickets
- impacts the price of g&s
- businesses use it to set prices
how do we measure inflation? (2)
- consumer price index (cpi) - looks at the prices of hundreds of things we commonly spend money on and tracks how these prices have changed over time
- retail price index (rpi) - the same as CPI but includes housing costs such as mortgage interest payments and council tax
what is the relationship between interest rates and inflation?
- if inflation is high banks will increase interest rates to reduce disposable income to curb spending
- reducing demand
what happens with demand pull inflation?
• AD shifts to the right,
-causing greater pressure on the factors of production to produce more output
-pushing prices up
explain the process of demand pull inflation (4)
• factors of production are becoming more scarcer and more pressure is being put on them
-this causes the resource to go up in price from factors such as wages and capital costs
-which increases the cost of production for firms
-these costs are then passed onto consumers via higher prices
what causes AD to shift to the right? (5)
• a reduction in interest rates making it cheaper for consumers to borrow and spend and cheaper for businesses to borrow and invest
• lower income tax increasing disposable income and lower corporation tax, increasing retained profits for businesses to invest
-higher consumer and business confidence
-higher government spending
• weaker exchange rate
what happens with cost plus inflation
-sras shifts to the left, when there’s an increase in the costs of production for majority of firms in the economy.
- burden of costs is passed onto consumer via higher prices
what are the causes of cost push inflation?
• increase in price of raw materials
• increase in businesses taxes (e.g.
VAT)
• increase in prices of imported raw materials because of a depreciation in the exchange rate
what are the different types of inflation?
(4)
shrinkflation
deflation (demand side and supply side)
hyperinflation
stagflation
- what is shrinkflation?
- occurs when firms reduce the size or quantity of a good and keeps prices the same
what are the implications of shrinkflation? (3)
- harder to calculate inflation as CPI works in the assumption that the basket of goods stays constant
- decline in customer trust - they can feel ripped off
- could be good for health in some cases (e.g. chocolate bars)
- what is deflation?
- what are the causes of deflation
- involved a fall in price level/ a negative rate of inflation
- can be bad
- fall in AD
- shift to the right of AS
- what is demand side deflation?
- what curve does it use?
- malignant/ bad deflation
- comes with lower growth
- long term and anticipated
- the economy shrinks so people won’t spend as much because they expect the economy to continue to shrink
- malignant/ bad deflation
- LRAS / AD
- what is supply side deflation?
- what curve does it use?
- good/ benign deflation
- comes with higher growth
- short term and unanticipated - SRAS/AD
what is hyperinflation?
- describes rapid excessive and out of control general price increases in an economy
- more than 50% per month
what is stagflation? / recession inflation
a situation in which the inflation rate is high, the economic growth rate slowed and unemployment remains steadily high
what are the advantages of inflation?
(4)
- moderate inflation allows economic growth
- moderate inflation allows adjustment of real wages
- moderate inflation allows adjustment of prices
- inflation is better than deflation that can cause a recession
what are the disadvantages of inflation?
- creates uncertainty and lower investment
- often leads to lower economic growth and less stability
- reduces international competitiveness
- can lead to recession
- fall in value of savings
- lower real wages if wages don’t keep up
what is an exchange rate?
the price of one currency in another currency
e.g. £1=$1.60
what is the is the exchange rate determined by?
•the forces of demand and supply for the currency
when demand for the pound shifts outwards what does this mean?
there’s an appreciation of the pound, the pound has got stronger ( can buy more of another currency )
what are the reasons for demand for a currency shifting outwards / appreciation of a currency? (5)
- increase in relative interest rates
( foreigners are attracted to save in a country because they get a higher rate of return on saving) swapping their currency for the pound thus increasing demand - traders anticipating a rise in the value of the pound, moving their money into pounds so they can take a profit
- increase in foreign direct investment ( foreign firms moving into UK will have to pay for factories workers and machinery in pounds)
- rise in incomes abroad ( foreigners demand UK exports that had to be paid in pounds
- increase in international competitiveness e.g. rise in investment and productivity ( increases demand for UK exports thus demand for the pound )
- what does it mean if a currency depreciates?
2.how can a currency depreciate?
- It can buy less of another currency
- if supply shifts the the right
what can cause supply to shift to the right/ a depreciation of a currency?
- fall in interest rates ( less of a return on holding money in bank)
- speculators/ traders anticipate a fall in the value of the pound so may move their money to a different currency
- decrease in foreign direct investment
- increase in domestic incomes ( people on the UK are demanding more imports, so pound needs to be exchanged for another currency )
what is a floating exchange rate?
when an exchange rate is determined by the forces of demand and supply for a given currency with no government manipulation
what is a fixed/ pegged exchange rate
when the government or central bank require to hold large amounts of domestic and foreign currency reserves to manipulate demand and supply of a domestic currency
what do authorities do if they fear that the exchange rate is going to rise when there is a fixed exchange rate/ to reduce value of exchange rate?
sell the pound using the currency reserves and buy a foreign currency to increase the supply of the pound
e.g. fixed rate = £1: $1.50
but equilibrium is at £1= $1.60
what do authorities do to rise the value of the exchange rate?
-increase demand for the pound by using foreign currency reserves to buy up more of the pound in the market
- shifting demand to the right
why would an economy want to decrease the value of a currency
to improve trade performance
- what words does a fixed exchange rate use
- what words does a floating exchange rate use?
- devaluing / revaluing
- appreciate / depreciate
what happens if a currency appreciates?
- SPICED (net exports are likely to decrease ) shifting AD to left
- imports are cheaper, cheaper commodity prices , decreasing costs of production shifting SRAS to the right lowering inflation.
what are the 3 complications of an appreciation of a currency
- lower growth bc exports falling, likely to worsen the current account deficit
- higher unemployment in exporting industries
- higher unemployment in domestic industries because less competitive
what are the 3 advantages of an appreciation of a currency?
- lower demand pull and cost plus inflation
- cheaper imports which is good for consumers, improving material standards of living
- potential efficiency gains for domestic producers as domestic firms can cut costs elsewhere, this may translate into lower prices
what happens if a currency depreciates?
- WIDEC
- increases AD, decreases SRAS
what are the advantages of a depreciation of a currency?
- higher employment in exporting industries
- higher employment in domestic industries because imports dearer generally
what are the advantages of a floating exchange rate? (4)
- reduces the need to hold large currency reserves which is costly and may not be viable
- freedom for domestic monetary policy ( some fixed systems require the manipulation of interest rates )
a floating exchange rate can correct a current account deficit because a deficit puts downward pressure on the currency’s value. This will reduce the value of the currency making imports more expensive and exports cheaper, correcting trade account deficit)
- A floating exchange rate provides insulation for export-dependent countries after an external shock because it allows the exchange rate to adjust. If there’s a decline in global demand, the currency depreciates, making exports more competitive and cushioning the impact on the domestic economy.
what are the disadvantages of a floating exchange rate?
- no guarantee floating exchange rates will be stable as exchange rates can be very volatile, reducing the incentive for foreign investors to invest in the domestic country where exchange rate is volatile
- self correction of trade deficit is unlikely to occur because imports and exports are only 2 factors that can affect demand and supply for a currency. other factors are more dominant e.g. speculation
what are the advantages of a fixed exchange rate? (3)
- certainty of currency encourages foreign investment and makes trade easier
- reduces the cost of trade, people concerned with exchange rates may buy in the future exchange rate market, to hedge against the potential rise in the currency in a floating exchange rate
- puts discipline on domestic producers because they can’t rely on an exchange rate falling in value so they have to increase efficiency
what are the disadvantages of a fixed exchange rate
- if interest rates are being used to maintain a fixed exchange rate, may come with consequences of negative growth and higher unemployment
- can a government actually hold large levels of foreign currency, it can be expensive and may not be viable for them
- speculative attacks if exchange rate is too high or too low
which exchange rates does most of the world use
floating bc positives outweigh fixed
what is forex
the foreign exchange market is a global decentralised or over the counter market for the trading of currencies
