Section 10 - Government Economic Policy Objectives Flashcards
What are the 4 main objectives for government macroeconomic policy?
- Strong economic growth
- Keeping inflation low
- Reducing unemployment
- Equilibrium in the balance of payments
Main objectives for government macroeconomic policy - strong economic growth
- Governments want economic growth to be high (but not too high).
- In general, economic growth will improve the standard of living in a country.
Main objectives for government macroeconomic policy - keeping inflation low
- In the UK, the government aims for inflation of 2%.
- The Monetary Policy Committee of the Bank of England uses monetary policy to try to achieve this target rate,
Main objectives for government macroeconomic policy - reducing unemployment
- Governments aim to reduce unemployment and move towards full employment.
- If more people are employed then the economy will be more productive. AD will also increase as more people will have a greater income.
Main objectives for government macroeconomic policy - equilibrium in the BoP
- Governments want an equilibrium in the balance of payments, i.e. they want earnings from exports and other inward flows of money to balance the spending on imports and other outward flows of money.
- This is more desirable than a long-term deficit or surplus in the BoP - which can cause problems.
Additional government objectives
>Balance the budget
>Protect the environment
>Achieve greater income equality
Economic growth - definition
>Economic growth is an increase in the productive potential of an economy.
Short-run economic growth
>In the short-run, economic growth is measured by the percentage change in real national output (real GDP).
>This is known as actual/real growth (inflation removed from growth figure).
>Increase in actual growth are usually due to an increase in AD, but can also be caused by increases in AS.
>Actual growth doesn’t always increase - it tends to fluctuate up and down.
Long-run economic growth
>Long run growth (also known as potential growth) is caused by an increase in the capacity, or productive potential, of the economy.
>This usually happens due to a rise in the quality or quantity of inputs.
>Long run growth is shown by an increase in the trend growth rate.
>Increases in long run growth are caused by an increase in AS.
Trend rate of growth
>The trend rate of growth is the average rate of economic growth over a period of both economic slumps and booms.
>It rises smoothly rather than fluctuating like actual economic growth, so the actual rate of growth often doesn’t match the trend rate.
PPFs and showing economic growth
>Short run and long run economic growth can be shown on a PPF.
>Short run growth is shown by a movement of a point towards the PPF, but the PPF itself remains fixed.
>Long run growth occurs if there’s an increase in the capacity of the economy - this would make the PPF shift outwards.
The Economic Cycle - phases
>The economic cycle has different phases.
>The actual growth of an economy fluctuates over time. These fluctuations are known as the economic cycle.
>Boom, recession, recovery.
>Long run growth is shown by an increase in the trend rate of growth. The trend rate of growth is the average rate of economic growth over a period of both economic booms and slumps.
>Also known as the trade or business cycle.
The Economic cycle - boom
>A boom is when the economy is growing quickly. AD will be rising, leading to a fall in unemployment and a rise in inflation.
The Economic cycle - recession
>A recession is when there’s negative economic growth for at least 2 consecutive quarters.
>AD will be falling, causing unemployment to rise and a fall in price levels.
The Economic cycle - recovery
>During a recovery the economy begins to grow again, going from negative economic growth to positive economic growth.
>AD will be rising, so unemployment will be falling and inflation will be rising.
Levels of investment
>Levels of investment tend to match the rate of change of GDP.
>This means investment will be greatest when the gradient of the actual growth is steepest.
Negative output gap
>A negative output gap (a.k.a recessionary gap) is the difference between the level of actual output and trend output when actual output is below trend output.
>A negative output gap will occur during a recession when the economy is under-performing, as some resources will be unused or underused (including labour, so unemployment may be high).
>A negative output gap also usually means downwards pressure on inflation.
Positive output gap
>A positive output gap (a.k.a an inflationary gap) is the difference between the level of actual output and trend output when actual output is above trend output.
>A positive output gap will occur during a boom when the economy is overheating, as resources are being fully used or overused (so unemployment may be low).
>A positive output gap also usually means upwards pressure on inflation.
What happens during a recovery?
>During a recovery an economy will go from having a negative output gap to having a positive output gap as actual output rises above trend output.
Benefits of economic growth
- Economic growth will increase demand for labour, leading to a fall in unemployment and higher incomes for individuals.
- Economic growth usually means that firms are succeeding, so employees may get higher wages. This will also produce a rise in the standard of living, as long as prices don’t rise more than the increase in wages.
- Firms are likely to earn greater profits when there’s economic growth, as consumers usually have higher incomes and spend more. Firms can use these profits to invest in better machinery, make technological advances and hire more employees - causing an increase in the economy’s productive potential.
- As firms are likely to produce more when there’s economic growth then this can improve a country’s balance of payments because it will sell more exports.
- Economic growth causes wages and employment to rise, which will increase the government’s tax revenue and reduce the amount it pays in unemployment benefits. The gov. can use this extra revenue to improve public services or h=the country’s infrastructure without having to raise taxes, which is good for individuals.
- Economic growth will improve a government’s fiscal position because if it receives greater tax revenue and spends less on things like unemployment benefits then this will reduce the gov’s need to borrow money.
- There might be some benefits to the environment brought about by economic growth, e.g. firms may have the resources to invest in cleaner and more efficient production processes.
Costs of economic growth
- It can create income inequality - low-skilled workers may find it hard to get the higher wages that other workers are benefitting from.
- Higher wages for employees are often linked to an increase in their responsibilities at work leading to increased stressed and reduced productivity.
- Demand-pull inflation can occur because it causes demand to increase faster than supply. It can also cause cost-push inflation as economic growth increases the demand for resources, pushing up their prices. However, the effects of inflation will be reduced if LRAS also increases.
- A deficit in the balance of payments can be created because people on higher incomes buy more imports. Furthermore, firms may import more resources to increase their production to meet the higher levels of demand.
- Industrial expansion created by economic growth may bring negative externalities, such as pollution of increased congestion which harm the environment and reduce people’s quality of life.
- Beautiful scenery and habitats can be destroyed when resources are overexploited.
- Finite resources may be used up in the creation of economic growth, which may constrain growth in the future and threaten future living standards.
Why is a recession bad?
>A recession will usually see many firms close down, with many people losing their jobs. This means unemployment usually increases.
>Other firms may stop hiring new employees - this means young people are often particularly badly hit.
>Gov. spending tends to increase leading to increased gov. borrowing and a budget deficit.
>Levels of investment fall - e.g. firms might reduce the amount they spend on R&D. This can have consequences for the long run productive potential of the economy.
Who can benefit from a recession?
>Some firms can benefit at times of recession - e.g. discount retailers can often attract more customers if people are feeling less confident about their economic prospects.
>Recessions can also force firms to face up to their inefficiencies. In good times, firms might be able to get away will being inefficient in some areas. But they may need to cut costs to survive a recession. This can benefit the firm in the long run if it emerges from the recession more efficient than it was before.
Short run economic growth - how can it be created?
- Rise in AD
- Rise in SRAS
What does the extent to which the AD curve shift depend on?
>People’s MPC
>How big the multiplier is.
Creating long run economic growth
>Long run economic growth is the result of supply-side factors that increase the productive potential of the economy.
>The productive potential of a country can be increased by raising the quantity or quality of the FoPs.
>A government can also help to create long run economic growth by creating stability in a country.
How can a country’s quality/quantity of FoPs be achieved?
- Through innovation (e.g. new technology).
- Investing in more modern machinery (i.e. improving capital stock).
- Raising agricultural output by using GM crops.
- Increasing spending on education and training to improve human capital.
- Increasing the population size, e.g. by encouraging immigration, to increase the size of a country’s workforce.
Instability in an economy
>It’s normal for an economy to go through regular ups and downs - this is the economic cycle.
>However, if these ups and downs are particularly large or particularly frequent, this can cause problems for an economy.
>Governments can try and control these ups and downs to a certain extent - but some thins are beyond their control.
Demand and supply side shocks
>An economy might start to shrink or grow because it is affected by a demand-side shock (AD rises or falls) or by a supply-side shock (AS rises or falls).
>These shocks can be domestic or global.
Examples of demand-side shocks
>If consumer confidence is boosted, e.g. due to house prices rising, this will increase consumer spending.
>If a country’s major trading partners go into a recession, this may significantly reduce demand for the country’s exports.
Examples of supply-side shocks
>A poor harvest reduces the supply of food, increases its price, and reduces the economy’s capacity.
>The discovery of a major new source of a raw material will greatly reduce its price and increase its supply - increasing the capacity of the economy.
What can cause instability?
>External shocks.
>Animal spirits
Instability - Animal Spirits
>According to classical economic theory, economic agents always act rationally.
>In fact, people often seem to act very irrationally. Keynes used the term animal spirits to describe how human behaviour is often guided by instincts and emotions, rather than economic realities.
>For example, the following are common danger signs for an economy - they often start to emerge during a boom but are followed shortly after by a bust, and created (at least partly) by animal spirits:
1. Excessive growth in credit and levels of debt.
2. Destabilising speculation and asset price bubbles.
Common danger signs for an economy
- Excessive growth in credit and levels of debt.
- Destabilising speculation and asset price bubbles.
Excessive growth in credit and levels of debt
>When credit is cheap and consumers are feeling confident, they often spend more and accumulate debt.
>This can increase AD and lead to higher inflation. This inflation can lead to higher interest rates, which could mean firms delay investment projects and become more cautious, storing up problems for an economy.
>High levels of debt also mean that it consumers lose confidence for any reason, they’re likely to greatly slow down their spending for fear of not being able to pay off their loans. It also means they’ll have less money to spend in the future, as they’ll be spending money repaying debts (including interest).
Destabilising speculation and asset price bubbles
>Speculation is when people buy assets (e.g. houses, shares, etc.) and hope to sell them for a profit later.
>Speculators often assume than increase in the price of an asset means that its price will continue to increase in the future - this prompts further buying of the good and further price increases, leading to further buying and further price increases, and so on. The herding effect has been used to explain why this behaviour may occur.
>This behaviour can lead to asset price bubbles - where prices increase way beyond the asset’s ‘true value’.
>Eventually, the bubble bursts and asset prices start to fall. When this happens, people’s optimism and confidence can disappear. If people start to fear they’ll lose money, they may start to sell the assets, leading to further price decreases, and further selling, and so on.
>Property and shares are often affected by asset-price bubbles, and the effects of a sudden fall in UK house prices, for example, can be dramatic. As people feel less wealthy and less confident, they start to save instead of spend, and this can lead to a downward spiral in the economy.
Capital stock - defintion
>Capital stock is the stuff that’s used to make goods.
Speculation - definition
>Speculation is when people buy assets (e.g. houses, shares, etc.) and hope to sell them for a profit later.
Herding effect
>Herding describes how people follow a crowd in the belief that ‘if everyone else is doing something then it must be the right thing to do.’
Sustainable economic growth - definition
>Sustainable economic growth means making sure the economy keeps growing (now and in the future), without causing problems for future generations.
What does sustainable growth rely on?
>Sustainable growth relies on a country’s ability to:
- expand output every year.
- find a continuous supply of raw materials, land, labour and so on, to continue production.
- find growing markets for the increased output, so it’s always being bought.
- reduce negative externalities, e.g. pollution, to an acceptable level so they don’t hamper production.
- do all of the above things at the same times as many other countries who are pursuing the same objectives.
Achieving sustainable growth
>It’s very difficult to achieve sustainable growth.
>To be able to achieve sustainable growth, countries need to develop renewable resources. Non-renewable resources will run out and, for growth to be sustainable, a continuous supply of raw materials is necessary.
>Countries will also need to innovate to create new technologies that reduce negative externalities, such as pollution, and the degradation of resources, such as land or rivers, without stopping output from expanding.
>A country that achieves sustainable growth will gain long-term benefits to society - it can easily plan ahead, since it can be more confident about its long-term economic prospects.
UK’s recent macroeconomic performance (textbook - i.e. may be outdated) - trade cycle
>From 2000 to 2008 the UK enjoyed continuous GDP growth of, on average, just under 3% each year. However, in 2008 the UK went into a recession that lasted for several months and was followed by a long, slow recovery.
>During the recovery the UK economy went through short bursts of growth followed by slow-downs - it almost went back into recession in 2012. From 2013 onwards, the UK has had much more consistent GDP growth and by 2014, GDP returned to the level it was just before the recession - suggesting that the recovery is complete.
UK’s recent macroeconomic performance (textbook - i.e. may be outdated) - inflation
>Between 2000 and early 2015 the rate of inflation in the UK, as measured by the CPI, has been quite steady - generally inflation has been between 0.5% and 3%.
>There have been some exceptions to this steady level of inflation.
>On a couple of occasions, inflation rose to about 5%, well above the government’s target of 2%. This happened just at the start of the recession in 2008 and again in 2011.
>Inflation then fell again and remained between 0 and 3% for some time.
UK’s recent macroeconomic performance (textbook - i.e. may be outdated) - unemployment
>Unemployment in the UK remained quite low between 2000 and 2008 - between about 1.4 to 1.7 million.
>It rose rapidly between 2008 and 2011, reaching about 2.7 million (8%).
>Since then unemployment has fallen, but, by January 2015, it was still higher than it was at the start of 2008.
UK’s recent macroeconomic performance (textbook - i.e. may be outdated) - extra
>The UK has had a current account deficit in its balance of payments for the whole period between 1984 and 2014.
>The deficit was at its largest during this period towards the end of 2014.
>The UK economy is currently dominated by its service sector, which accounts for approximately 77% of GDP.
>Manufacturing now accounts for just around 10% of GDP.
Full employment - definition
>The situation when everyone of working age who wants a job at the current wage rates can get one.
Full employment - info
>Governments aim for full employment.
>Full employment doesn’t mean everyone has a job - in most economies there will always be people between jobs.
>Governments want full employment because this will maximise production and raise standards of living in a country.
>If there’s unemployment, the economy won’t be operating at full-capacity (point within PPF curve). At full employment the economy can operate at full capacity (point on the PPF curve).
>Under-employment would also mean an economy isn’t operating at full capacity.
Under-employment
>Under-employment would mean an economy is not operating at full capacity, and it will be represented by a point within its PPF curve.
>Under-employment is when someone has a job, but it’s not a job that utilises that persons skills, experience or availability to best effect.
>E.g. someone who could only find part-time employment when they actually wanted a full-time position.
What affect unemployment?
>Economic growth and the time of year.
Unemployment - economic growth
>Labour is a derived demand - an employer’s demand for labour is derived from consumers’ demand for goods/services.
>So when demand in the economy is low (e.g. when there’s negative economic growth), unemployment will rise. When demand is high, it will fall.
>Cyclical unemployment (or demand-deficient unemployment) usually happens when the economy is in a recession - when AD falls, employment will too.
>A country suffering from a negative output gap is likely to have cyclical unemployment too.
>Cyclical unemployment can affect any industry.
Unemployment - time of year
>Seasonal unemployment occurs because demand for labour in certain industries won’t be the same all year round.
>E.g. tourism and farming industries have ‘peak’ seasons where the need for labour is much higher than at other times of year.
>Retailing is also affected by seasonal unemployment (many shops will be particularly busy at Christmas).
>Seasonal unemployment tends to be regular and predictable, and it only affects certain industries.
Structural unemployment
>Structural unemployment is caused by a decline in a certain industry or occupation - usually due to a change in consumer preferences or technological advances, or the availability of cheaper alternatives.
>It often affects regions where there’s a decline in traditional manufacturing (e.g. shipbuilding or the steel industry).
>It’s made worse by labour immobility (occupational and geographical).
>If a region is affected by structural unemployment then it could also suffer from the negative multiplier effect, causing further unemployment in the region due to less spending.
>The problem of structural unemployment may become more common in the future.
Why may the problem of structural unemployment may become more common in the future?
>Technological change in both products and production methods is accelerating quickly. This will speed up the decline of out-of-date industries and reduce the number of workers needed to make products.
>Consumer spending is more likely to change as consumers are better informed (through the internet and social media) than ever before - making them more likely to switch to lower priced or higher quality goods.
Labour immobility - types
>Occupational
>Geographical
Occupational labour immobility
>Occupational labour immobility occurs when some occupation may decline over time, but the workers in these occupations don’t have the skills required to be able to do the jobs that are available.
Geographical labour immobility
>Geographical labour immobility is where workers are unable to leave a region which has high unemployment to go to another region where there are jobs.
> This might be because they can’t afford to move to a different region, or they have family ties.
Frictional unemployment
>Frictional unemployment is the unemployment experienced by workers between leaving one job and starting another.
>Even if an economy is at full employment, there will be some frictional unemployment. There will always be some employees changing jobs - maybe because their contract has run out or they want to earn higher wages.
>The length of time people spend looking for a new job (the ‘time lag’ between jobs) depends on several things.
What does the length of time people spend looking for a new job depend on?
>In a boom the number of job vacancies is much higher. So frictional unemployment is likely to be short term.
>In a slump frictional unemployment could be much higher as there will be a shortage of jobs.
>Generous welfare benefits will give people less incentive to look for a new job, or they can mean people can afford to take their time to look for a good job - so the time spent between jobs may increase.
>The quality of information provided to people looking for jobs is important too. If people don’t know what jobs are available or what skills they need to get the job they want, then they’re likely to remain unemployed for longer.
>Occupational and geographical labour immobility will also effect the time lag between jobs.
Real wage unemployment
>Real wage unemployment is caused by real wages being pushed above the equilibrium level of employment (where labour D=S).
>It’s usually caused by trade unions negotiating for higher wages or by the introduction of a national minimum wage.
>Introducing a NMW above the equilibrium wage rate would cause unemployment due to excess supply.
>However, a rise in productivity or consumer spending would increase the demand for labour (labour demand curve shifts right) and his would reduce the size of the increase in unemployment.
Migration and unemployment
>Migration of workers into a country increases the supply of labour.
>When the economy is strong, national income should increase as a result of migration - especially if the skills and knowledge of the migrant workers is different from the mix of skills of the country’s native population. There’s little evidence from the UK that migration during a boom increases unemployment among the native population.
>During a recession, unemployment among native workers (especially low-skilled workers) may increase, especially if migration levels are particularly high. However, even these effects weaken over time.
Costs and consequences of unemployment
>The unemployed will have lower incomes, which means that they’ll spend less and this could reduce firm’s profits.
>Unemployment will mean less tax revenue for governments, and less consumer spending will reduce their indirect tax revenue. The gov. also have to spend more on unemployment benefits.
>Areas with high unemployment can have high crime rates, and reduced incomes can cause people to have health problems.
>Workers who are unemployed for a long time may find that their skills and training become outdated. This will reduce their employability and make it more likely that they’ll stay unemployed. Hysteresis.
Types of inflation
>Cost-push inflation
>Demand-pull inflation
Cost-push inflation - definition
>Cost-push inflation is inflation caused by rising costs of production.
>Rising costs of inputs to production force producers to pass on higher costs to consumers in the form of higher prices, which causes the AS curve to shift to the left.
Cost-push inflation examples
- A rise in wages above any increase in productivity:
- if wages make up a large proportion of a firm’s total costs then this could lead to a significant rise in prices.
- price rises could lead to further wage demands, which in turn could lead to price increases, and so (this is a wage-price spiral). - A rise in the cost of imported raw materials:
- if the world prices of inputs rise then, in the short run, producers will pay the higher cost and set higher prices. This is how price increases in world commodity markets can lead to higher domestic inflation.
- also, if a country’s currency decreases in value then producers will have to pay more for the same imports. - A rise in indirect taxes:
- if the gov. raises indirect taxes this will increase costs and in turn, prices.
- if a good is price inelastic then more of the cost of the tax will be passed on to the consumer.
Demand-pull inflation - definition
>Demand-pull inflation is inflation caused by excessive growth in AD compared to supply.
>This growth in demand shifts the AD curve to the right, which allows sellers to raise prices.
Causes of demand-pull inflation - list
- High consumer spending or high demand for exports.
- The money supply growing faster than output.
- Bottleneck shortages.
Causes of demand-pull inflation - high consumer spending or high demand for exports
>High consumer spending could be caused by high levels of confidence in consumers’ future employment prospects. Low interest rates encourage cheap borrowing and greater spending.
>High foreign demand for exports could be caused by rapid economic growth in other countries.
Causes of demand-pull inflation - the money supply growing faster than output
>If the amount of money in the economy is not matched by the output of goods and services (a.k.a ‘too much money chasing too few goods), this can lead to a rise in prices. This might be the case, for example, when interest rates are low and consumers are spending more.
>Monetarists economists believe that excess money is the biggest cause of inflation.
Causes of demand-pull inflation - bottleneck shortages
>If demand grows quickly at a time when labour and resources are already being fully used, then increasing output may lead to shortages (i.e. there may be a positive output gap). These shortages will cause prices to rise and firm’s costs to increase.
>Price rises caused by shortages (e.g. a rise in wages for skilled labour) in one area of the market may be copied by other markets (e.g. higher wages for low-skilled labour), leading to more general inflation.
Quantity of Money Theory - formula
> money supply x velocity of money = price level x aggregate transactions.
>MV = PT.
Quantity of Money Theory - info
>The quantity theory of money is based on Fisher’s equation of exchange.
>On the left-side is M (= the total amount of money in the economy) and V (=the speed at which money is spent). On the right-side is P (=the price level) and T (= the total amount of transactions in the economy).
>Monetarists argue that, in the short run, V and T are unlikely to change, so any increases in P, the price level, will be directly caused by an increase to M, the money supply. Both sides of the equation are assumed to be equal to each other, so any increase in the money supply (M) will create the same percentage increase in the price level (P).
>To avoid inflation, monetarists believe that the money supply needs to be strictly controlled.
>There’s evidence to suggest that this theory is useful for explaining high levels of inflation, but is not so good when looking at more modest inflation.
Costs and consequences of inflation
- Inflation will cause the standard of living of those on fixed, or near-fixed, incomes to fall. This will have the biggest impact on those in low income employment or on welfare benefits.
- A country’s competitiveness will be reduced by inflation as exports will cost more to buy and imports will be cheaper. If exports fall and imports rise, then this could create a deficit in the balance of payments and increase unemployment.
- Inflation discourages saving because the value of savings falls. This makes it more attractive to spend (creating demand-pull inflation) before prices rise further.
- A reluctance to save creates a shortage of funds for borrowing and investment, which means that it’s harder for firms to make improvements, e.g. buy new machinery. If interest rates go up to reduce inflation, this will also reduce investment.
- Inflation creates uncertainty for firms as rising costs will reduce investment - harming future growth.
- Shoe-leather costs, which are the costs of the extra time and effort taken by consumers to search for up-to-date price info on goods and services they’re using, and menu costs, which are the extra costs to firms of altering the price information they provide to consumers.
- An extreme case is hyperinflation, where inflation grows very quickly to very high levels (e.g. several hundred percent or more). It’s often as a result of governments creating too much money (e.g. because of a war or some other crisis).
Deflation - definition
>When the rate of inflation falls below 0% it’s called deflation.
provide example features of the economic cycle
What is the impact of inflation from AD vs. from AS on the diagram?
How can AS be affected by productivity growth vs. higher prices on the diagram?
Where can output gaps be demonstrated on the diagram and why?
Demonstrate the negative and positive output gaps on an AD/AS diagram.
Demonstrate lomg economic growth on a PPF and AD/AS diagram
