Steering the Macroeconomy Flashcards
What are the main economic aims of the government?
- low and stable inflation (price stability)
- high level of employment and low level of unemployment
- to encourage economic growth
- to encourage trade and secure a favourable balance of payments
What is Fiscal policy?
Controlling AD by altering the balance between government expenditure and taxation
-government changing the levels of taxation and government spending in order to influence Aggregate Demand (AD) and the level of economic activity.
Purpose of fiscal policy
□ Stimulate economic growth in a period of a recession.
□ Keep inflation low (UK government has a target of 2%)
□ Fiscal policy aims to stabilize economic growth, avoiding a boom and bust economic cycle.
What are some automatic stabilisers of economy?
□ If the economy is growing, people will automatically pay more taxes (VAT and Income tax) and the Government will spend less on unemployment benefits.
□ The increased T and lower G will act as a check on AD.
□ in a recession, the opposite will occur with tax revenue falling but increased government spending on benefits, this will help increase AD
what is discretionary policy?
this is a deliberate attempt by the government to affect AD and stabilize the economy,
e.g. in a boom the government will increase taxes to reduce inflation
what is the public sector borrowing requirement
(G + Ig) – T = PSBR
Current public (G) and Capital Public (Ig) Spending
Is discretionary policy effective?
fiscal policy can be used toincrease Aggregate Demand.These policies can be used tohelp close thedeflationary gap
Problem of discretionary fiscal policy
The government may have poor information about the state of the economy and struggle to have the best information about what the economy needs
Multiplier; Accelerator; Crowding out; Random shocks Adverse effects; Time lags; Uncertainty: how will people react? Destabilising policy;
fiscal policy cannot help an economy produce at an output level above potential GDP without causing inflation
how is crowding out a problem?
Some economists argue that expansionary fiscal policy (higher government spending) will not increase AD because the higher government spending will crowd out the private sector.
This is because the government have to borrow from the private sector who will then have lower funds for private investment.
why are time lags a problem
to increase government spending will take time.
It could take several months for a government decision to filter through into the economy and actually affect AD. By then it may be too late.
what is monetary policy?
Using interest rates, the money supply and the exchange rate to control AD and meet targets through
□ Inflation targeting
□ Economic growth
How effective is monetary policy?
In a recession:
- interest rates are lowered, reserve limits loosened, and bondsare purchased in exchange for newly created money
- Lower interest rates will reduce incentive to save and hence encourage consumption; reduce cost of borrowing and so stimulate consumption and investment.
- will reduce the exchange rate and hence boost exports and decrease imports. Also it reduces variable rate mortgages and so increases disposable income and boosts consumption
Inflation too high:
-the central bank will enact restrictive monetary policy to tighten the money supply, effectively reducing the amount of money in circulation and lowering the rate at which new money enters the system
What is the role of the central bank in monetary policy?
□ In a recession: an undertake unconventional monetary policies such asquantitative easing(QE)
□ when inflation is high, enacts restrictive monetary policy
What happens when interest rate is raised?
investment becomes more expensive and works to sloweconomic growtha bit.
Cons of changing interest rates
® set too low, over-borrowing at artificially cheap rates can occur
® Adding more money to the economy = out-of-control inflation
◊ if more money is available in circulation, the value of each unit of money will be worth less given an unchanged level of demand, making things priced in that money nominally more expensive.
® interest rates can only be lowered nominally to 0%, which limits the bank’s use of this policy tool when interest rates are already low
® Monetary policy tools such as interest rate levels have an economy-wide impact
define quantitative easing
refers to steps that the U.S. Federal Reserve takes in attempting to boost the country’s lagging economy
Define supply side policies
Supply-side policies are government attempts to increase productivity and shift aggregate supply (AS) to the right
What are the supply side policies?
Free-market supply-side policies
Interventionist supply-side policies
What is Free-market supply-side policies
involve policies to increase competitiveness and competition.
For example, privatization, deregulation, lower income tax rates, and reduced power of trade unions.
what is Interventionist supply-side policies
involve government intervention to overcome market failure.
For example, higher government spending on transport and communication.
benefits of supply side policies
- Lower Inflation
□ Shifting AS to the right will cause a lower price level. By making the economy more efficient, supply-side policies will help reduce cost push inflation. - Lower Unemployment
□ Supply-side policies can contribute to reducing structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment. - Improved economic growth
□ increase the sustainable rate of economic growth by increasing LRAS;
□ this enables a higher rate of economic growth without causing inflation. - Improved trade and Balance of Payments.
□ firms more productive and competitive; export more. This is important in light of the increased competition from an increasingly globalized marketplace.
examples of free-market oriented policies
Privatisation
- sell state-owned assets to the private sector, improve incentives
Deregulation
-new firms enter market- open monopolies to competition
Income tax cuts
-greater incentive to work longer hours
Remove regulations/ red tape
-easier to build new factories/ housing
Flexible labour markets
-reduce power of trade unions, min wages and regulations
Free-trade agreements
-reduce tariff barriers + obstacles to trade
Reduce welfare benefits
-increase the incentive to get a job
Examples of interventionist policies
Public sector investment
-infrastructure - improve transport and reduce costs
Education
-increase funding to schools an universities- improve labour productivity
Vocational training
-gov’t schemes to provide new skills to those who lose jobs
Housing supply
-increase the supply of council housing improve geographical mobility
Health spending
-public spending on health can reduce hours lost to ill-health
limitations of supply-side policies
-Productivity growth depends largely on private enterprise and trends in technological innovation.
- Supply-side policies can be counter-productive.
e. g. flexible labour markets may reduce costs for business - In a recession, supply-side policies cannot tackle the fundamental problem which is lack of aggregate demand.
-Time.
take a long time to have an effect.
what is a supply side shock?
Globalisation,
Harmonisation,
Contagion
Impact of a financial crisis on businesses
§ Credit/lending conditions and Zombie companies □ Zombie- struggling to service interest payments § Rationalisation and integration § Wage bills § Outsourcing § Location changes § Management structures § Oil and commodity prices
What causes a change in demand and supply of money?
○ Buying habits- demand
○ Liquidity ratio- supply
E.g. low liquidity ratio, supply shifts to the right
define appreciation
If exchange rate increases-
define depreciation
If exchange rate decreases-
n.b. Excess supply of pounds leads to a depreciation
what is are the different exchange rates?
Floating exchange rate (appreciation or depreciation)
Fixed exchange rate (revaluation of devaluation)
Factors that could lead to a depreciation of the £
○ Higher inflation in UK than abroad
○ A rise in UK incomes
○ Fall in UK interest rates
○ Relative investment prospects improving abroad
○ Speculation that the rate will fall
○ Uncertainty about the economy and its prospects
• Note: if prices in UK is depreciating, prices in EU is appreciating
The effect of the lower pound
○ Exports more competitive (cheaper)
○ Imports more expensive (including imports)
○ Import cost-push inflation
○ The demise of Monarch (fuel priced in dollars)
- Revenue earned in £; costs incurred mainly in $ and each £ is worth fewer $
What happens when the pound falls
- As pounds fall, uk consumers will move money from UK bank to a EU bank, so supply increases
- Eu consumers will move their money from a UK bank to a EU bank, demands therefore decreases
Overall ER goes down
what happens when money supply increases
• Imports and exports depends on ER
• At original interest rate, X1 and M1
• When money supply increases, lower interest rate, depreciation of exchange rate
○ Export more- demand increases
○ Import less
§ i.e. goods are more competitive, cheaper price as £ worth less
- Injections curve shifts upwards
- Withdrawal shifts downwards
- Increase in national income
effect of increase in money supply
- Reduces interest rates
- Cuts borrowing costs
- Boosts investment (accelerator)
- Cuts saving
- Reduces the exchange rate
- Cuts imports
- Increases exports
- Boosts growth (multiplier)
- Cuts unemployment
- Increases inflation
What is the ISLM model?
The relationship between the goods and money markets
• Used to analyse how changes in one market affects the other
Goods- IS- investment saving
Money- LM- liquidity of money
How steep or flat the IS curve is depends on…
• Depends on how responsive I and S are
○ Greater change, flatter IS curve
○ Lower level of change, steeper IS curve
• The multiplier
○ More withdrawal, less money is circulating
○ Large marginal propensity to save, less money is spent in economy, more money withdrawn, size of MPS affects S curve
○ Big multiplier, flatter IS curve
define Quantitative Easing
the central bank buys assets (mostly government debt) through OMOs (open market operations)
○ This raises the price and lowers the yield on long term government debt
○ This reduces the long term rate of interest…
As we saw in many countries around the world
IS curve
(J=W)
At any point on this curve, goods market is in equilibrium
Downward sloping
how steep or flat the LM curve is?
When Y increases, how much more money do I need?
- Greater increase in the demand for money L, greater rate of interest, steeper LM curve
- Flatter the L curve, flatter the LM curve
Central bank role in unemployment issues
E.g. unemployement
IS 1 -> 1S2. - increase in gov. spending
To Increase in employment
However,
Causes interest rates to also increase
Crowding out effect- firms spend less
Make increase inflationary pressures
Central bank can help keep interests stable to solve unemployment issues
So they boost money supply- increases
Even higher level of NI, but interest rate stays the same
Fiscal and monetary policies are most effective when used together
How does macroeconomics (FP and MP etc.) impact firms?
Taxes rise
- Firms costs rise > profits hit
- Yd falls > less consumer spending > lower AD > fewer jobs
Interest Rate rise
- borrowing costs rise > investment falls > profits hits, AD falls
- consumer borrowing costs rise > spending falls > firms face lower D
- exchange rates fall > import costs rise > inflation
- lower spending and AD > fewer jobs > lower AD
What happens when AD rises or falls?
AD rises > higher inflation; higher wages; higher costs
AD falls > fewer customers; higher unemployment; less investment; lower profits
