Section 11 - Macroeconomic Policy Instruments

Question 1

Fiscal policy - definition

Answer 1

> Fiscal policy (or budgetary policy) involves government spending (public expenditure) and taxation.
It can be used to influence the economy as a whole (macroeconomic effects) or individual firms and people (microeconomic effects).

Question 2

What can fiscal policy be used for?

Answer 2

> Fiscal policy can be used to stimulate aggregate demand.

Question 3

Types of fiscal policy

Answer 3

1. Reflationary fiscal policy (a.k.a ‘expansionary’ or ‘loose’ fiscal policy) involves boosting AD by increasing government spending or lowering taxes. It’s likely to involve a government having a budget deficit.
2. Deflationary fiscal policy (a.k.a ‘contractionary’ or ‘tight’ fiscal policy) involves reducing AD by reducing government spending or increasing taxes. It’s likely to involve a budget surplus.

Question 4

Budget deficit - quick point

Answer 4

government spending > revenue.

Question 5

Budget surplus - quick point

Answer 5

government spending < revenue.

Question 6

Expansionary fiscal policy

Answer 6

> Is likely to be used during a recession or when there’s a negative output gap.
It’ll increase economic growth and reduce unemployment, but it’ll also increase inflation and worsen the current account of the balance of payments because as incomes increase, more is spent on imports.

Question 7

Contractionary fiscal policy

Answer 7

> Is likely to be used during a boom or when there’s a positive output gap.
It’ll reduce economic growth and increase unemployment, but it’ll also reduce price levels and improve the current account of the balance of payments because as incomes fall, less is spent on imports.

Question 8

Governments fiscal stance

Answer 8

> A government’s fiscal stance or budget position describes whether a policy is reflationary (known as expansionary stance), deflationary (known as contractionary stance), or neither (a neutral stance).
If a government has a neutral fiscal stance then government spending and taxation has no net effect on AD.

Question 9

2 important features of fiscal policy

Answer 9

1. Automatic stabilisers

2. Discretionary policy

Question 10

Automatic stabilisers

Answer 10

> Some of a government’s fiscal policy may automatically react to changes in the economic cycle.
During a recession, government spending will increase because the government will pay out more benefits, e.g. JSA. The government will also receive less tax revenue, e.g. due to unemployment.
These automatic stabilisers reduce the problems a recession causes, but at the expense of creating a budget deficit.
During a boom, the automatic stabilisers create a budget surplus as tax revenue increases and government spending on benefits falls.

Question 11

Discretionary policy

Answer 11

> This is where governments deliberately change their level of spending and tax.
At any given point a government might choose to spend on improving the country’s infrastructure or services, and increase taxes to pay for it.
On other occasions the government might take action because of the economic situation, e.g. during a recession the government might spend more and cut taxes to stimulate AD.

Question 12

Structural budget position - definition

Answer 12

> A structural budget position is a government’s long-term fiscal stance.
This means their budget position over a whole period of the economic cycle, including booms and/or recessions.

Question 13

Cyclical budget position - definition

Answer 13

> A cyclical budget position is a government’s fiscal stance in the short term.
This is affected by where the economy is in the economic cycle - automatic stabilisers are likely to create a surplus (i.e. a contractionary budget position) during a boom and a deficit (i.e. an expansionary budget position) during a recession.

Question 14

Budget deficits and surpluses

Answer 14

> A budget deficit caused by an expansionary cyclical budget position is known as a cyclical budget deficit.
This will be balanced out by a budget surplus during boom times when the cyclical budget position is contractionary.
A budget deficit caused by an expansionary structural budget position where spending is more than revenue in the long term will add to national debt. This is called a structural budget deficit.

Question 15

Taxes - features

Answer 15

> Taxes should be:

• cheap to collect
• easy to pay
• hard to avoid
• shouldn’t create any undesirable disincentives (e.g. discourage people from working or from saving).

Question 16

What may governments want taxes to achieve?

Answer 16

> Governments may want taxes to achieve horizontal and vertical equity:

• Horizontal equity will mean that people who have similar incomes and ability to pay taxes should pay the same amount of tax.
• Vertical equity will mean that people who have higher incomes and greater ability to pay taxes should pay more than those on lower incomes with less ability to pay taxes.

Question 17

What may governments also want taxes to promote?

Answer 17

> Promote equality in an economy
This might involve using taxes to reduce major differences in people’s disposable income, or to raise revenue to pay for benefits and the state provision of services.

Question 18

How do governments raise tax?

Answer 18

> Governments raise tax through direct taxation (e.g. income tax) and indirect taxation (e.g. VAT or excise duty).
They also use different tax systems to achieve different economic objectives - the ones you need to know are progressive, regressive and proportional taxation.

Question 19

Progressive taxation

Answer 19

> Progressive taxation is where an individual’s taxes rise (as a percentage of their income) as their income rises, and it’s often used to redistribute income and reduce poverty.
A government can use the tax revenue from those on high incomes and redistribute it to those on low incomes in the form of benefits or state-provided merit goods - increasing equality.
Progressive taxation follows the ‘ability to pay’ principle (the tax achieves vertical equity.)

Question 20

Regressive taxation

Answer 20

> Regressive taxation is where an individual’s taxes fall (as a percentage of their income) as their income rises, and they’re used by governments to encourage supply-side growth.
By reducing the taxes of the rich the government will hope that the economy will benefit from the trickle-down effect.
A regressive tax system gives people more incentive to work harder and earn more income, but it may increase inequality.

Question 21

Proportional taxation

Answer 21

> Proportional taxation (a ‘flat tax’) is where everyone pays the same proportion of tax regardless of their income level.
This tax system can achieve horizontal equity, but setting a fair tax rate to apply to all members of society is difficult.
For example, a 25% tax on income might be too high for those on lower incomes to afford, and it might not raise enough revenue from those on higher incomes for the government to be able to pay for all of the public goods and services it provides.

Question 22

Flat tax - for

Answer 22

> Supporters of a flat tax argue that it can simplify the tax system, reduce the incentive to evade and avoid paying taxes (flat taxes often charge high earners less than variable rates), and increase the incentive to earn more.

Question 23

Flat tax - against

Answer 23

> Flat tax rate systems may bring in less tax overall than variable tax rate systems.
Flat rate tax systems also don’t have vertical equity, but they can be made more progressive by having a tax free allowance (where you don’t pay any tax until you earn a certain amount).

Question 24

Argument against increasing tax rates

Answer 24

> Supply-side economists argue that increasing direct taxes creates a disincentive to work and will reduce a government’s tax revenue. This is shown on the Laffer curve.
The Laffer curve shows that as taxes increase, eventually this will lead to a decline in tax revenue because people will have less incentive to work.

Question 25

What can the size of government spending be affected by?

Answer 25

1. The size and structure of a country’s population. A country with a large population will require greater levels of gov spending, and a country with an ageing population will have greater demand for state-funded health care.
2. Government policies on inequality, poverty and the redistribution of income will alter the amount of government spending - this may vary from gov to gov based on their political views. E.g. a gov that wants to redistribute income may spend more on benefits.
3. The fiscal policies governments use to tackle certain problems in a country will also have an effect. During a recession a gov may increase public spending to encourage growth and reduce unemployment, but if these policies lead to a large national debt then the gov may introduce ‘austerity measures’ and severely reduce their spending.

Question 26

Definition - budget deficit

Answer 26

> A budget deficit (PSNB - Public Sector Net Borrowing) is what a government borrows in a single year.

Question 27

Definition - national debt

Answer 27

> The national debt (PSND - Public Sector Net Debt) is the total debt (run up over time).

Question 28

Budget deficit

Answer 28

> A budget deficit (PSNB) must be paid for by public sector borrowing, so that the government can spend more money than it receives in revenue.
In the UK, the government can borrow the money it needs from UK banks, which will create deposits that the government can spend. It can also borrow money from the private sector by selling Treasury Bills, which the government will pay off over a period of time, or it can borrow money from the foreign financial markets.
This kind of borrowing is fine in the short run, especially if the borrowed money is used to stimulate demand in a country. But there will be problems if there’s excessive borrowing.
Continued government borrowing will increase a country’s national debt (PSND). A large and long-term national debt can cause several problems too.

Question 29

Problems caused by excessive borrowing

Answer 29

1. Excessive borrowing could cause demand-pull inflation, partly due to the fact that government borrowing increases the money supply, so there’s more money in the economy than can be matched by output.
2. As borrowing may cause inflation, it can also lead to a rise in interest rates to curb that inflation. Higher interest rates will discourage investment by firms and make a country’s currency rise in value, meaning that its exports are less price competitive.
3. Methods to correct a budget deficit will depend on what kind of budget deficit it is.

Question 30

Problems caused by a large and long-term national debt

Answer 30

1. If a country’s debt becomes very large then it may cause firms and foreign countries to stop lending money to that country’s government. This will constrain the country’s ability to grow in the future.
2. Future taxpayers will be left with large interest payments on debt to pay off. Debt repayments have an opportunity cost as future governments may have to cut spending to pay off debt, which may harm economic growth.
3. A large national debt suggests that there’s been excessive borrowing, which causes inflation and interest rates to rise. It also suggest that public sector spending is very large, which may ‘crowd out’ private sector spending. Although, if government spending boosts the economy there may be ‘crowding in’ instead (public sector spending may increase private sector spending) - firms will invest more if the economy is growing quickly.
4. A country with large debt is less attractive to FDI, as foreign countries will be uncertain how the debtor nation’s economy will do in the future and whether it will be a good bet for investment.

Question 31

How the kind of budget deficit determines methods to correct it

Answer 31

> A cyclical budget deficit is caused by recessions and comes about due to a government’s automatic stabilisers (when gov spending on benefits increases and tax revenue falls). This kind of deficit will be corrected when the economy recovers again - the deficit will be replaced by a surplus.
However, a structural budget deficit, caused by excessive borrowing, is much harder to solve. To cure this problem governments will have to raise taxes and reduce public spending so that they can pay off their debt (‘austerity measures’). However, these actions could harm economic growth and cause other problems.

Question 32

Budget surplus - cons

Answer 32

> A budget surplus is generally more desirable than a budget deficit - however, it’s not always a good thing either.
A budget surplus might suggest that taxes are too high or that governments aren’t spending enough on the economy. Both these things could harm or constrain economic growth.
Lowering taxes or increasing government spending would correct a budget deficit.

Question 33

How do governments avoid overspending?

Answer 33

> They follow fiscal rules

Question 34

Fiscal rules

Answer 34

> The UK government first brought in fiscal rules in 1997. One of these was the golden rule - over the economic cycle the government can borrow to invest in things like infrastructure (which should generate future growth), but cannot borrow to fund current expenditure (e.g. wages).
Following fiscal rules like these should help to prevent a government from continuously borrowing and overspending to promote growth, which increases national debt and inflation. It’ll also help governments to achieve economic stability as they’ll avoid uncertainty and fluctuating inflation.
Fiscal rules can also influence the behaviour of businesses and consumers, by increasing confidence in future economic stability. E.g. consumers may be more willing to spend and firms may increase investment if they’re confident in the country’s economic stability.
However, this will only work if there is a belief that governments will keep to the rules they’ve set. E.g. there was disagreement over whether the golden rule was actually being followed between 1997 and the 2008 financial crisis, as it’s not clear how an economic cycle is defined. (The rule was abandoned after 2008).
In 2010, the UK gov created the Office for Budget Responsibility (OBR) to help the government keep its fiscal policy under control.

Question 35

OBR

Answer 35

> > In 2010, the UK government created the Office for Budget Responsibility (OBR) - an independent body that:
1. Publishes reports analysing UK public spending, taxation, and government predictions of future spending.
2. Assesses the performance of the government against the fiscal targets it’s set for itself.
3. Uses long-term projections to analyse how sustainable government spending and revenue is.
By doing this, the OBR helps the government to keep its fiscal policy under control.

Question 36

Using fiscal policy to tackle poverty

Answer 36

> Fiscal policy can be used to reduce poverty in a country. 3 key ways a government can do this is through benefits, provision of certain goods and services, and progressive taxation.
Government spending on benefits, e.g. JSA, pensions and disability benefits, is a way of helping those who are unemployed or unable to work, and reducing absolute poverty.
A gov can also spend its tax revenue to provide goods and services, such as free health care or education, to enable those who are suffering from poverty to have access to these things.
Furthermore, by providing some goods and services to poorer members of society, a government will be investing in improving the country’s human capital - i.e. this spending may make labour much more productive.
Progressive taxation may reduce relative poverty by narrowing the gaps between people’s disposable income, and the revenue raised can pay for benefits and the state provision of goods and services. On top of this, governments could provide tax cuts and discounts for the poor.
Finally, if fiscal policy creates growth, then this may reduce both relative and absolute poverty. Greater economic growth will mean more jobs, higher incomes and a better standard of living.

Question 37

Key ways a government can use fiscal policy to reduce poverty

Answer 37

1. Benefits
2. State provision of certain goods and services
3. Progressive taxation

Question 38

Monetary policy - intro

Answer 38

> Monetary policy involves making decisions about interest rates, the money supply and exchange rates.
Monetary policy has a huge effect on AD - it’s a demand side policy.
The most important tool of monetary policy is the ability to set interest rates. Changes to interest rates affect borrowing, saving, spending and investment.
Interest rates also affect other components of monetary policy - the money supply and exchange rates. E.g. a high interest rate can restrict the money supply as there’ll be less demand for loans.
Monetary policy can either be contractionary or expansionary.

Question 39

Contractionary monetary policy

Answer 39

> This involves reducing AD using high interest rates, restrictions on the money supply, and a strong exchange rate.

Question 40

Expansionary monetary policy

Answer 40

> This involves increasing AD using low interest rates, fewer restrictions on the money supply, and a weak exchange rate.

Question 41

Monetary policy aims

Answer 41

> As with demand-side fiscal policy, monetary policy can’t help achieve all of a government’s macroeconomic objectives simultaneously - there’s a trade-off.
For example, using monetary policy to increase economic growth and reduce unemployment may mean increasing inflation and worsening the current account of the balance of payments.
In the UK, the main aim of monetary policy is to ensure price stability - i.e. low inflation. But it also has the aims of promoting economic growth and reducing unemployment.

Question 42

Who sets the interest rates in the UK?

Answer 42

> MPC (Monetary Policy Committee)
The Monetary Policy Committee of the Bank of England sets interest rates in order to meet the inflation target that’s set by the government - this target is currently 2% inflation, as measured by the Consumer Price Index. This is known as inflation-rate targeting.

Question 43

MPC and interest rates

Answer 43

> The Monetary Policy Committee of the Bank of England sets interest rates in order to meet the inflation target that’s set by the government - this target is currently 2% inflation, as measured by the Consumer Price Index. This is known as inflation-rate targeting.
The MPC has a symmetric target - if the inflation rate misses the 2% target by more than 1% in either direction, then the governor of the BoE has to write to the Chancellor.

Question 44

What would the MPC do if they believed inflation was likely to go above 3%?

Answer 44

> It would increase the official rate of interest (sometimes called the Bank Rate or Base Rate) to reduce AD and keep inflation close to 2%.

Question 45

Central banks and inflation targets

Answer 45

> The MPC has a symmetric target - if the inflation rate misses the 2% target by more than 1% in either direction, then the governor of the BoE has to write to the Chancellor.
Some central banks have an asymmetric inflation target.
E.g. the European Central Bank (ECB) aims to keep inflation close to but below 2%.

Question 46

Why is a low rate of inflation desirable?

Answer 46

> A low rate of inflation that’s stable and credible stops higher rates of inflation becoming embedded in the economy.
It also helps the government achieve macroeconomic stability - a high or rapidly changing rate of inflation creates uncertainty, prevents investment, and makes it difficult to plan for the future.
To achieve this stability and credibility the BoE is independent and accountable.

Question 47

Why is the BoE independent and accountable?

Answer 47

> To achieve this stability and credibility the BoE is independent and accountable.
The BoE’s independence means that interest rates can’t be set by the government at a level that will win votes, but which might not be right for economic circumstances at the time.
The BoE is accountable - if the inflation rate is more than 1% away from the target rate, then the Bank’s governor must write an open letter to the Chancellor explaining why, what action the MPC is going to take to deal with this, and when they expect inflation to be back within 1% of the target.

Question 48

MPC - considerations

Answer 48

> Although price stability is the main objective of monetary, the BoE must pursue this in a way that doesn’t harm the government’s other macroeconomic policy objectives (e.g. economic growth or low unemployment).
When the MPC is making a decision on interest rates it will look at important economic date, such as:
-house prices
-the size of any output gaps
-the pound’s exchange rate
-the rate of any increases or decreases in average earnings.
The MPC has to consider interest-rate changes very carefully, since these changes can have a huge effect.

Question 49

Ripple effect

Answer 49

> Even very small changes in interest rates can create a ‘ripple effect’ through the whole economy.
Here are some likely effects of an increase in interest rates:
-less borrowing, consumption, investment and confidence
-more saving
-a decrease in exports and an increase in imports.
Decrease = opposite effects.
However, when people are particularly pessimistic about the future state of the economy, they may prefer to keep hold of the money they already have (rather than spend or invest it), and they’re unlikely to want to borrow any more. In this case, lowering interest rates won’t create the above ‘ripple effect’, and monetary policy will become ineffective. This situation is known as a liquidity trap.

Question 50

Markets and interest rates

Answer 50

> The Bank Rate is the lowest rate at which the BoE will lend to financial institutions. But it isn’t the rate of interest that you’d pay if you applied for a mortgage or loan.
However, these various types of interest rates are linked.
But the Bank Rate is not the only thing that affects these ‘market’ interest rates.
For example, banks often need to borrow the money that they lend out to firms and consumers from other lenders. If lots of banks are trying to borrow money at the same time, then they’ll have to pay a higher rate of interest themselves, which will affect the cost of mortgages and loans they offer to consumers.

Question 51

What are interest rates affected by?

Answer 51

1. Bank Rate
2. Supply and demand for credit
   >Other things

Question 52

Interest rates and exchange rates

Answer 52

> When interest rates are high in the UK, big financial institutions want to buy the pound. They do this so that they can put their money into UK banks and take advantage of the high rewards for savers brought about by high interest rates. This is likely to be a short-term movement of money and it’s called ‘hot money’.
An increased demand for the pound means its price goes up - exchange rate rises.
Unfortunately, a high exchange rate makes UK exports more expensive.
When this happens exports go down, worsening the current account on the balance of payments.
For the same reason, high UK interest rates mean imports from abroad become cheaper. Again, this worsens the current account.
Imports are also a leakage in the circular flow of income, and so spending more on imports reduces AD.

Question 53

What happens when UK interest rates fall (in terms of exchange rate)

Answer 53

1. Exchange rate of the pound falls.
2. UK exports increase as UK goods become cheaper and imports decrease as foreign goods become more expensive.
3. The balance of payments improves.

Question 54

What shows the effect of interest-rate changes?

Answer 54

> The transmission mechanism.

Question 55

The transmission mechanism - intro

Answer 55

> The knock-on effects that a change to the official Bank Rate can have are best shown by the transmission mechanism.
The end result of any change in the official Bank Rate will be a change to the level of inflation.
In the exam, if you need to consider the effect on an economy of a change in interest rates, you need to think of transmission mechanism.

Question 56

Transmission mechanism ‘diagram’

Answer 56

1. Official bank rate
2. market rates, asset prices, expectations/confidence, exchange rate
3. domestic demand, external demand
4. total demand
5. Domestic inflationary pressure, import prices
6. Inflation

Question 57

Transmission mechanism example - reduction in official Bank Rate

Answer 57

1. Suppose the BoE reduces the official Bank Rate.
2. Other interest rates (e.g. mortgage and saving rates) will probably fall too as a result. Saving becomes less attractive and borrowing becomes more attractive.
3. This affects asset prices (e.g. prices of houses and shares) - these are likely to rise (since people tend to buy more assets when interest rates are low). If mortgage rates go down, demand for houses is likely to increase, pushing prices up. And if IRs fall, savers will see shares as a better way to get a return on their savings.
4. People and firms will also generally feel more confident about the future, which will make them want to spend or invest - leading to an increase in domestic demand.
5. Lower interest rates will also generally mean a fall in the exchange rate which leads to increased demand for UK exports.
6. The result of all this is that total demand in the economy rises.
7. The price of imports will also generally rise as a result of the fall in the exchange rate.
8. The end result is that there’s upwards pressure on the level of inflation in the economy.

Question 58

Time and monetary policy

Answer 58

> The effect of changing IRs isn’t felt straight away - it takes time for the effects to feed through the transmission mechanism.
E.g., reducing IRs won’t usually cause a sudden surge in investment or house buying:
-firms plan investment projects very carefully - it can take several months/years before they increase their spending.
-house buying can also take a long time - people need to find a suitable home, and the purchase can take a long time too. Fixed-rate mortgage holders won’t notice the effect of an IR change until their fixed-rate period ends.
In fact, the time lags between changes in the Bank Rate and its effect on the economy can be very long indeed:
-the maximum effect on firms is usually felt after about one year.
-the maximum effect on consumers is usually felt after about two years.
So the BoE has to look up to 2 years into the future when it’s making a decision about interest rates.

Question 59

Supply-side policies - intro

Answer 59

> The aim of supply-side policies is to expand productive potential (i.e. LRAS) of an economy, or to increase the trend rate of growth.
Supply-side policies are about the government creating the right conditions to allow market forces to create growth as opposed to the government creating growth directly by, for example, increasing its spending.
Supply-side policies involve making structural changes to the economy to allow its ‘individual parts’ to work more efficiently and more productively.
Can be free-market or interventionist policies.
The effects of supply-side policies are generally microeconomic - i.e. their direct effects are usually on individual workers, firms or markets. However, these changes can have a powerful macroeconomic effect.
Supply-side policies make an economy more robust and flexible.

Question 60

What do supply-side policies involve?

Answer 60

> Supply-side policies involve making structural changes to the economy to allow its ‘individual parts’ to work more efficiently and more productively.
For example, they might do this by helping markets function more efficiently.
Or creating incentives for firms or individuals to become more productive (or more entrepreneurial).
High taxes can create unhelpful disincentives to work - supply-side policies may aim to correct these.

Question 61

Types of supply-side policies

Answer 61

1. Free-market

2. Interventionist

Question 62

Free-market supply-side policies - definition + examples

Answer 62

> Free-market supply-side policies aim to increase efficiency by removing things which interfere with the free market.
They include tax cuts, privatisation, deregulation, and policies to increase labour market flexibility.

Question 63

Interventionist supply-side policies - definition + examples

Answer 63

> Interventionist supply-side policies are usually aimed at correcting market failure.
They include gov spending on education, subsidies for R&D, funding for improvements to infrastructure (e.g. ports that help firms export their goods), and industrial policy.

Question 64

What is industrial policy?

Answer 64

> Policy aimed at developing a particular industry or sector of the economy, e.g. through subsidies.

Question 65

Supply-side policy examples - the product market

Answer 65

1. Create incentives for firms to invest, for example, offer firms tax breaks if they invest profits back into the business instead of paying dividends to shareholders.
2. Trade liberalisation - this means removing or reducing trade barriers, and allowing goods and capital to flow more freely between countries.
3. Encourage competition, for example:
   - deregulation can lead to improved efficiency in a market.
   - privatisation may be effective if nationalised industries are inefficient.
   - contract services out (this means the government asks private firms to bid to carry out services on its behalf though the government retains responsibility for the services.
   - provide extra support for new and small firms, or make it easier to set up a new company.

Question 66

Supply-side policy examples - the capital market

Answer 66

> Deregulation of financial markets:
-e.g. The ‘Big Bang’ of 1986 removed a lot of the traditional ‘restrictive practices’ that were felt to have made British financial market inefficient.

Question 67

Supply-side policy examples - the labour market

Answer 67

1. Reduce unemployment benefits: to create incentives for people to take a job (even a low-paid one) rather than live on benefits. Making it easier for people to find out about what jobs are available can also help.
2. Reduce (or reform) income tax: introducing progressive taxation with the aim of creating more more incentives for people to work (e.g. by ensuring people don’t become worse off it they take a job or earn a pay rise.
3. Improve education and training: e.g. apprenticeships allow people to learn practical skills while gaining relevant qualifications. Improvements in education will not only allow employees to become more productive but can also lead to greater occupational mobility.
4. Improve labour market flexibility: e.g. through trade union reforms, or by making it easier for firms to make workers redundant when times are tough.
5. Reduce regulations on firms - this would reduce firms’ non-wage costs and may encourage them to employ more workers.

Question 68

What are needed alongside supply-side policies

Answer 68

> Suitable demand-side policies are needed alongside supply-side policies.
Supply-side policies aim to make an economy more able to supply products. But for maximum benefit there needs to be a demand for those products - this means appropriate demand-side policies.
The Keynesian AS curve shows how increasing supply doesn’t help when demand is very low. It also means that during a global recession, supply-side policies might not have their full impact until other countries’ economies start to recover as well.
Nowadays supply-side and demand-side policies are often used together but to achieve different aims:
-Supply-side policies create long-term growth.
-Demand-side policies stabilise the economy in the short-term.

Question 69

Example - tackling unemployment

Answer 69

> Using an expansionary fiscal policy to boost AD might reduce unemployment. However, a supply-side economist would say that reducing unemployment in this way doesn’t change the NRU. So when the effects of your expansionary fiscal policy end, unemployment is likely to return to its ‘pre-boost equilibrium.’
A supply-side approach to this problem might be to try to reduce the NRU itself, i.e. create a new equilibrium position in the labour market. The hope is that this effect is likely to be more long-lasting. In the diagram, for example:
-Tax breaks encouraging firms to invest have created greater demand for labour (ADL curve shifts right).
-Increased incentives to work have created a greater supply of labour (the ASL curve shifts right too).
-The overall effect is that the equilibrium position in the labour market has moved to the right (meaning employment has risen, and that the NRU should fall).
However, demand-side policies can still be useful in tackling short-term surges in unemployment.

Question 70

Benefits of supply-side policies

Answer 70

> Increasing the economy’s trend growth rate makes it easier for a government to achieve its macroeconomic objectives, with fewer conflicts between objectives - which isn’t the case with demand-side policies.
For example, unemployment should fall as the economy grows and output expands.
And cost-push inflation should be reduced, as greater efficiencies (and lower costs) are achieved.
The current account on the BOP should also improve because of increased international competitiveness.

Question 71

Supply-side policies - drawbacks

Answer 71

1. It can take a long time to see the results so they can’t be used to fix the economy quickly.
2. There can be unintended consequences - e.g. deregulation of financial markets starting with the ‘Big Bang’ in 1986 led to excessive risk-taking in financial markets, which contributed towards the recent recession.
3. Supply-side policies can be unpopular, and there are also concerns about whether some are inequitable (inequality has increased in the UK since early 1980s):
   - E.g. benefit cuts can lead to the poorest people in society worrying about their ability to cope financially.
   - greater flexibility in the labour market and trade-union reforms could lead to some people having less job security.
4. So while a gov. may hop that improved economic performance will lead to greater prosperity overall in the long term, it can be very difficult in the short term to introduce some of these policies.

Question 72

Keynesian Fiscal Policy

Answer 72

> The experience of the Great Depression contributed to rising interest in the work of Keynes, which argued that gov. spending could boost an economy during recession and get it back on track.
Keynesian demand management policies of adjusting gov. spending to control economic growth were popular in the middle of the 20th Century - in the UK the gov. focused on full employment, and adjusted taxation and spending to influence demand and try and smooth out the economic cycle. Relies on multiplier effect.
There was steady growth and near full employment in the UK in the 1950s and 1960s, as well as fairly low and stable inflation. There were boom and bust cycles, but the downturns were fairly week.

Question 73

Keynesian beliefs on how the economy adjusts

Answer 73

> Keynesians believe that the government often needs to intervene to get the economy closer to reaching full employment, and operating at full capacity.
They think when there’s a shock like a recession that causes AD to drop, it takes a very long time for demand to recover, because prices and wages adjust slowly. So the economy is likely to be operating below capacity (below full employment) for a long time, unless the gov. steps in to boost demand.
Classical economists think that the economy generally operates at full capacity, because wages and prices easily adjust.
Monetarists take the classical view, i.e. economy is quick to adjust back to full capacity.

Question 74

Governments approach to fiscal policy - supply-side fiscal policy

Answer 74

> Supply-side fiscal policy is used to increase AS, which will help a government achieve all four of its main economic objectives (unlike demand-side fiscal policy).
For example, tax cuts could be offered to entrepreneurs to encourage them to start up new businesses that will increase productive potential of economy.

Question 75

Governments approach to fiscal policy - fiscal policy

Answer 75

> Fiscal policy is used on a microeconomic level to influence the behaviour of consumers and firms.
For example, demerit goods are taxed to decrease consumption, and merit goods can be provided by the state or subsidised to increase their consumption.
Fiscal policy can also be used to help governments achieve their environmental policy objectives.
For example, the government could introduce ‘green taxes’ that discourage the use of coal or oil, or provide subsidies to firms that use renewable energy.

Question 76

Governments approach to fiscal policy - regional

Answer 76

> Government spending can be directed at specific regions that need extra help.
For example, if a region loses a big employer and is suffering from structural unemployment, then the government could invest in that region to create jobs, or enccourage firms to move there with subsidies and tax breaks.

Question 77

Governments approach to fiscal policy - tax

Answer 77

> Progressive taxation allows the government to redistribute wealth from those who are better off to those who are less well off.