Theme 2: Macroeconomic Objectives and Policies Flashcards
The 4 main Macroeconomic objectives
- Economic growth
- Low unemployment
- Low and stable rate of inflation
- Balance of payments equilibrium on current account
What is the UK’s long run trend of economic growth goal?
2.5% of sustainable economic growth
What is the aim for rate of unemployment in the UK?
3%
What is the government’s target inflation rate? and at what point does the Governor of the Bank of England write a letter to the Chancellor of the Exchequer?
2% and if the target falls 1% outside target
Why is the balance of payments in equilibrium important for the current account?
So the country can sustainably finance the current account, which is important for long term growth.
What are the 3 additional government macroeconomic objectives?
- Balanced government budget
- Protection of the environment
- Greater income equality
Why does the government want to keep control of state borrowing?
So the national debt does not escalate. This allows governments to borrow cheaply in the future should they need to, and makes repayment easier.
What is Monetary Policy and how does it achieve their aims? Who controls it?
Used by the government to control aggregate demand within the economy. Through controlling interest rates and quantitate easing. (controlled by the Bank of England MPC (monetary policy committee).
What is Fiscal Policy and how does it achieve their aims? Who controls it?
Uses government spending and revenues from taxation to affect AD within the economy (controlled by the government.
How do interest rates affect aggregate demand? EXPANSIONARY MONETARY POLICY
As they alter the cost of borrowing and the reward for saving. The bank controls the base rate which controls interest rates. A reduction is the base rate will lead to a rise in AD.
Cut in I/R will reduce the cost of borrowing. Cheaper for consumers to borrow. Disposable income increases allowing them to spend on houses, cars- increases C shifting AD to the right from AD1 to AD2
§ Cut in I/R reduces the rate of return on savings. This reduces the incentive to save and increases the incentive to spend or borrow to spend. Savings ratio will decrease, consumption increases shifting AD to the right from AD1 to AD2
§ Reduces the monthly payments for those with tracker or variable mortgages. Monthly, these homeowners will receive a boost to their disposable income; increase MPC thus boosting C shifting AD to the right from AD1 to AD2.
§ Higher consumption, due to lower borrowing, will mean that asset prices increase. This will lead to a positive wealth effect.
§ Reduces the cost of borrowing for firms enabling them to reach their hurdle more easily. Increases MP to invest increasing I in AD shifting AD to the right from AD1 to AD2
If relative UK interest rates fall, investors will move heir money out of UK financial institiuons in order to chase better interest rates. Lower interest rates reduce the incentive for investors to hold their money in British banks there’d be hot money outflows from the UK increasing supply of the pound. A weak E/R makes exports cheaper and imports dearer. Improvement in the trade balance reduce a CA deficit or move it to a surplus. As (X-M) is a component of AD, shifting AD to the right from AD1 to AD2
§ Higher rates will increase the incentive for foreigners to hold their money in British banks as they can see a higher rate of return. As a result, there will be increased demand for pounds and the value of the pound will rise . This means that imports will be cheaper, and exports will be more expensive. This decreases net trade and therefore AD.
There are some problems with this method of demand management
§ The exchange rate may be affected so much that exports fall significantly and imports rise significantly, causing a balance of trade deficit.
§ Banks might not pass the base rate onto consumers, which means that even if the central bank changes the interest rate, it might not have the intended effect
§ Changes in interest rates take up to 2 years to have their full effect and small changes in interest rates may not affect people’s decisions.
§ Sometimes, interest rates are so low that they cannot be decreased any further to stimulate demand
§ There are a range of different interest rates and not all of them are affected by the Bank of England base rate
§ A lack of confidence in the economy may mean that, no matter how low interest rates are, consumers and
businesses do not want to borrow or banks do not want to lend to them.
§ High interest rates over a long period of time will discourage investment and decrease LRAS.
How does quantitative easing affect an economy and when is it used?? WITH advantages and disadvantages
It increases the money flow which in theory encourages more investment, more spending and hopefully higher growth. It is used when inflation is low and it is not possible to lower interest rates further.
Helps to stimulate economy when standard MP is no longer effective, not possible to lower interest rates further.
§ Inflationary effects since it increases the money supply, and it can reduce the value of the currency.
§ It can prevent the liquidity trap, where even low interest rates cannot stimulate AD.
§ Banks buy assets in the form of government bonds using the money they have created- used to buy bonds from investors, which increases the amount of cash flowing in the financial system. This encourages more lending to firms and individuals, cost of borrowing lower. The theory is that this encourages more investment, more spending, and hopefully higher growth.
§ A possible effect of this is that there could be higher inflation. If inflation gets high, the Bank of England can reduce the supply of money in the economy by selling their assets. This reduces the amount of spending in the economy.
ADVNATAGES:
Gives a central bank an extra tool of monetary policy besides changing interest rates
§ Increasing the size of the monetary base helps to lower the threat of price deflation. Without QE the fall in real GDP would have been deeper and the rise in unemployment greater
§ Lower long term interest rates have kept business confidence higher and given the commercial banking system extra
deposits to use for lending
§ QE can lead to a depreciation of the exchange rate which helps to improve the price competitiveness of export
DISADVANTAGES:
§ May contribute to rising wealth inequality because of surging house prices and housing rents- worsens geographical mobility
§ Increase in the monetary base might lead to inflationary pressure
§ Ultra low interest rates can distort the allocation of capital and also keep alive zombie companies (key criticism of
Hayekian/ Austrian school)
§ Low interest rates has reduced the annual incomes from pension funds making life tougher for those with savings and who rely on their occupational pension
§ It had a large effect on the housing market by stimulating demand and leading to rapid price rises since 2013, helping
to worsen the issues of geographical mobility. It also led to rising share prices which increases inequality, since the rich grow richer whilst the poor see none of the gains.
PROCESS:
- Electronic money on balance sheets
- Purchase bonds from a financial
institution- increase price of bonds - Yields of bonds fall
- Financial institutions- increase
cash/ liquidity - Banks increase lending theoretically
= more cash + cheaper credit - Low i/r – increase consumption
+investment - Currency depreciates due to capital
outflows
3 Limitations of monetary policy. EXPANSIONARY MONETARY POLICY CONS AND EVAL
- Banks might not pass on the base rates to consumers.
- Banks might be more risk averse so not want to lend.
- Most only work when consumer and firm confidence is high.
CONS:
Demand pull inflation- as spare capacity is being exhausted more competition for resources and pressure is put on existing FOP increasing the price of them. Puts upward pressure on price – DPI
§ I/R cannot fall below 0 (liquidity trap); Keynesian argument I/R after a given point loses their effectiveness when they hit their lower bound. When they hit this economy enters liquidity trap. Consumers and businesses convert their illiquid financial assets into cash to facilitate spending or investment, hoarding. If the central bank tries to cut I/R further consumers already have lots of cash no need to borrow, won’t see increase in consumption, investment if I/R are already low.
§ Large negative impact on savers. Wealth inequality with the poor struggling to find assets with a good return rich are more likely to take a risk and search to find higher yielding assets
EVALUATION:
The initial level of economic activity. Economy is in large negative output gap- increase in AD = larger output and decrease in U/E. Due to spare capacity, potentially no DPI pressures, not making exports less competitive and worsening CA position
Consumer confidence- consumers need to be confident- low I/R incentive to borrow and spend.
Low consumer confidence, cutting I/R doesn’t guarantee spending
Business confidence- need to be confident in profitability and demand- reason to invest when I/R are low. When business confidence is low it doesn’t guarantee more borrowing for investment. AD is unlikely to increase if at all leaving the four key macroeconomic objectives of government unaltered.
The length of time lags for I/R (monetary policy) having an effect on the economy. 2 years for it to feed through and have an impact on economy. A change in I/R- feeds through the transmission mechanism affecting house prices, commercial bank I/R
Whether banks are willing to lend and willing to pass on the full rate cut. Banks in times of deep recession or crisis are concerned with liquidity and profitability. Their willingness to take risks is low, reducing willingness to lend. Even if banks are willing to lend- may only pass on a small percentage of the rate cut for consumers and firms and thus the positive AD impact.
As AD increases due to expansionary monetary policy
§ Growth- actual growth increases from Y1 to Y2. With greater demand firms respond by increasing output exhausting spare capacity; Y2 is closer to YFE output. This increase in output is an increase in real GDP, increase in economic growth
§ Unemployment- decreases, labour= derived demand. Demand for goods and services is high, firms will need more workers to produce extra output- reducing u/
What is the biggest source of tax revenue for the government in the UK?
Income tax
What 3 things does the UK spend most of the budget on?
- Pensions and welfare benefits
- Health
- Education
Expansionary fiscal policy WHAT CAN THEY DO AND WHAT DOES IT CAUSE
Aims to increase AD. Governments increase spending or reduce taxes. Leads to worsening of the government budget deficit, governments might have to borrow more.
- Government can reduce the marginal rate of income tax for those in lower income tax bands or increase tax free allowance. Increase AD, MPC increase
- Government can reduce marginal rate of income tax on rich, increased disposable income which will be spent in economy increasing AD- multiplier effect.
- Reduce levels of regressive taxes such as VAT. Frees up more income for poor to spend AD increases
Governments can reduce the level of corporation tax. Increase retained profits- investment AD to AD1
Governments can boost spending on infrastructure, education, healthcare, wages. G is core component- significantly increase AD- generates large multiplier effect- final GREATER increase in AD
AS AD INCREASES DUE TO EXPANSAIONARY FISCAL POLICY:
Growth- actual growth increases from Y1 to Y2. With greater demand firms respond by increasing output exhausting spare capacity; Y2 is closer to YFE output. This increase in output is an increase in real GDP, increase in economic growth
Unemployment- decreases, labour= derived demand. Demand for goods and services is high, firms will need more workers to produce extra output- reducing u/e
Governments can boost spending in the economy by spending on infrastructure; healthcare etc.
increases the quantity and quality of the capital stock. Investment in education and healthcare – increase the productivity of labour; quality. Infrastructure- increase productive efficiency of the economy making it quicker, easier and cheaper to transport goods and services nationally and internationally. Increase LRAS from LRAS1 to LRAS2
Deflationary fiscal policy
Aims to decrease AD. Government cut spending or raise taxes, which reduces consumer spending. Improvement of government budget.
Budget (fiscal) deficit and advantages and disadvantages
When expenditure exceeds tax receipts in a financial year.
Advantages:
Fiscal stimulus could create a positive multiplier effect, stimulates investment, output levels increase. Injection into circular flow of income
§ Fiscal stimulus from 2008-10 prevent economy falling into a recession
§ Keynesians advocate fiscal policy to deal with external shocks- stabilise economy
Disadvantages
Continued gov borrowing increase national debt- firms and foreign countries stop lending money to the gov- constrain country’s ability to growth
Large national debt – excessive borrowing- inflation and interest rates to rise
Less attractive to FDI- foreign countries uncertain how the debtors nation’s economy will do in future and whether it’s a good bet for investment
Crowding out- classical economists believe low gov spending crowds out private sector. Transfer of resources from private to public
Financial crowding out- govt increase bond yields to attract investors to buy bonds. Yield on govt bonds increase = I/R increase bonds- crowds out private sector distorting investment and capital expenditure decrease, growth decreases
Eval of crowding out:
Future tax payers burdened with tax in l/r. May reduce incentives to work
§ Demand pull inflation and overheating- depends upon spare capacity, inelastic or elastic
§ Bond yields are low- reality and likelihood of crowding out is slim
§ Just a theory may not work in presence
§ Bond yields at an all-time low- crowding out is slim
§ Probability of crowding out is low with lots of spare capacity
Keynesian economists counter that well-targeted and timely stimulus spending helps to support growth, output, jobs and competitiveness. Indeed higher government spending can be partially self-financing and an important policy option when private demand is depressed
Budget (fiscal) surplus
When tax receipts exceed expenditure
Direct taxes
Imposed on income and paid directly to the government from the tax payer. e.g. income tax, corporation tax and inheritance tax.
Indirect tax
Imposed on expenditure on goods and services and increase the cost of production for producers. They increase market price and demand contracts.
Unemployment vs inflation
As economic growth increases, unemployment falls due to more jobs being created. However, this causes wages to increase, which can lead to more consumer spending and an increase in the average price level.
Short run Phillips curve: A. W. Phillips found a trade-off between inflation and unemployment, called the Phillips curve. The rate of change in money wages increased as the rate of unemployment fell. This was then generalised into a relationship between unemployment and inflation by arguing that firms pass on increases in wages to the customer in increased prices.
§ The reason for this connection is that businesses know that if there is a high level of unemployment, they can attract the workers they want with low wages.
§ If there is high employment, firms are competing for the best workers and the way to obtain the best is by offering higher wages. Passed onto consumers through higher prices- cost push inflation. Initially, the Phillips curve seemed to accurately show the relationship well.
§ However, during the 1970s we saw high levels u/e, high inflation, called stagflation
lower level of unemployment is accompanied by high levels of inflation. Long run there’s said to be no conflict between these obj
