Theme 2 - Macroeconomic Objectives and Policies Flashcards
What are the macroeconomic objectives for the government?
Key:
Economic growth
Low unemployment
Low and stable inflation
Balance of payments equilibrium on the current account
Other:
Balance government budget
Protection of the environment
Greater income equality
Government objectives: economic growth
UK long run trend is about 2.5%.
Governments aim to have sustainable economic growth for the long run. In emerging and developing economies governments may aim to increase economic development before economic growth, which will improve living standards, increase life expectancy and improve literacy rates
Government objectives: low unemployment
Governments aim to have as near full employment as possible. They account for frictional unemployment by aiming for an unemployment rate of around 3%. The labour force should also be employed in productive work
Government objectives: low and stable inflation
In the UK, the government target is 2%, measured by CPI
This aims to provide price stability for firms and consumers and will help them make decisions for the long run. If the inflation rate falls 1% outside the target, the governor of the Bank of England has to write a letter to the Chancellor to explain why this has happened and what they plan to do about it
Government objectives: balance of payments equilibrium on the current account
This is important to allow the country to sustainable finance the current account, which is important for long term growth
Government objectives: balance government budget
This ensures the government keeps control of state borrowing so the national debt doesn’t escalate. This allows governments to borrow cheaply in the future should they need to and makes repayments easier
Government objectives: protection of the environment
This aims to provide long run environmental stability. It ensures resources used are not exploited, such as oil and natural gas, and that they are used sustainably, so future generations can access them too. It also means there is not excessive pollution
Government objectives: greater income equality
Minimises the gap between rich and poor. Generally associated with a fairer society
What are demand side policies?
Policies designed to manipulate consumer demand
Expansionary policies aim at increasing AD to bring about growth
Deflationary policies aim at reducing AD to control inflation
What is monetary policy?
Where the central bank or regulatory authority attempts to control the level of AD by altering base interest rates of the amount of money in the economy
What is fiscal policy?
The use of borrowing, government spending and taxation to manipulate the level of aggregate demand and improve macroeconomic performance
What is the repo rate?
The rate the Bank of England will charge for short-term loans to other banks or financial institutions. A change in the repo rate adducts market rates offered by banks to consumers and businesses as the BoE is the lender of last resort
How does a rise in interest rates cause a fall in AD?
- Increases the cost of borrowing for firms and consumers. Leads to a fall in investment and consumption. In particular, consumption of consumer durables and houses will fall. Also makes saving more attractive
- As people borrow less and save more, there is a fall in demand for assets such as stocks, shares and bonds, causing a fall in the prices of these assets. Consumers experience a negative wealth effect, which will lead to a fall in consumption, and investment is less attractive as firms are likely to see lower profits if prices fall
- People become less confident about borrowing and spending, causing a fall in consumption and investment. Other loans also become more expensive to repay so consumers have to dedicate more of their income to paying these back, so consumption will fall
- Higher rates increase incentive for foreigners to hold their money in British banks as they see a higher rate of return. This increases the demand for pounds and the value of the pound will rise, so imports cheaper and exports more expensive, which decreases net trade.
What are the problems with using interest rates to manage levels of aggregate demand (monetary policy)?
- if exchange rate affected so much that exports fall and imports rise significantly, there could be a balance of trade deficit
- Time lags; changes in interest take up to 2 years to have their full effect, and some may not even affect peoples decisions
- Sometimes interest rates are so low that they cant be decreased further to stimulate demand
- Range of interest rates, and not all are affected by the BoE base rate
- Lack of confidence may mean that consumers and producers don’t want to borrow, no mater how low interest is
- High rates over a long period of time discourage investment and decrease LRAS
What is quantitative easing?
When the BoE buys assets in exchange for money to increase the money supply and prevent the liquidity trap (where even low interest rates can’t stimulate AD)
What is the effect of QE?
Increases consumption and investment
How does QE increase consumption and investment, and ensure the country meets its inflation target?
- Since the bank is buying assets, there is a rise in demand, so asset prices rise, causing a positive wealth effect, increasing consumption. Cost of borrowing decreases as higher asset prices mean lower yields making it cheaper for households to finance spending
- The money supply increases. private sector companies receive more money which they can spend on goods and services, or other financial assets, which may increase investment, or consumption and therefore increase AD. It may also push asset prices up further. Banks have higher reserves so they can increase lending to households and businesses so consumption and investment increase as people can buy on credit
- Commercial banks may lower their interest rates as they are receiving money from the BoE and can offer very low interest deals to their customers. The increased money supply means that the price of money falls, which will encourage borrowing and therefore increase investment and consumption, so increase AD. If many banks decide to lower their interest rates the same mechanisms will apply as those following a reduction in the base rate
What are the problems with using QE?
- It is very risky, and if not controlled properly could cause high inflation, or hyperinflation
- Could only lead to increased demand for secondhand goods, which pushes up prices but doesnt increase AD
- No guarantee that higher asset prices lead to higher consumption through the wealth effect
- Had a large effect on the housing market by stimulating demand and leading to rapid price rises by 2013, worsening issues of geographical immobility
- Led to rising share prices which increases inequality
- Over-dependence on QE
Alternative methods to QE
- Open market operations; to reduce monetary supply, the central bank can sell more government securities on the open market. Securities are a promise by the government to pay a certain amount of money to the owner at a certain time and their are bought for less than their actual value; their price is determined by the demand for them. When people buy securities they pay for them with money drawn from banks and so there is a fall in the bank balances. This means banks meed to reduce their lending so monetary supply will fall. If they want to increase monetary supply the central bank can buy government securities
- The central bank can force banks to hold certain assets as a percentage of their total assets, known as monetary base or reserve assets. This means they can control the amount of money that is loaned out and therefore the money supply
- The central bank can restrict a bank’s ability to lend money, or who they are allowed to lend it to
What is the role of the Bank of England?
- Its monetary policy committee controls monetary policy
- Main aim is to keep inflation at 2%, and if it goes below 1% or above 3% the governor of the BoE has to write a letter to the Chancellor explaining why and what they are doing to bring it back
Since 2009, the MPC has kept the bank rate at 0.5% and policy has become focussed on boosting economic growth and employment. It was reduced to 0.25% following the Brexit vote but rose again in November 2017 due to the inflation that the weak pound brought about. They plan to raise the interest rate once the negative output gap has been eliminated and the economy is growing strongly. - The Committee is made up of nine people: five are from of the Bank of England, including the Governor of the Bank of England, and the other four are independent outside experts, mainly economists.
What are the two main ways a government can increase AD through fiscal policy?
- Rise in income tax will cause a fall in disposable income, leading to reduced consumption, and a fall in AD
- Rise in govt. spending will increase AD
Government budgets
The government’s fiscal plans are outlined in the budget. A budget deficit is when the government spends more money than they receive. A budget surplus is when the government receives more money than they spend.
What are the problems with fiscal policy?
- Gov spending can also impact LRAS
- Taxes and spending have an impact on inequality and incentives
- Government also has to worry about political issues
- Expansionary fiscal policy difficult during a period of austerity
- Impact depends on the multiplier; classical argue multiplier is almost 0, Keynesian say it is large
Evaluation of demand side policies
Classical economists argue that any demand management, whether fiscal or monetary, will have no effect on long-run output so supply side policies should be used. They believe that increasing AD during a depression will have no effect other than to increase prices. If the economy is in short-run disequilibrium, it will quickly return to long run equilibrium, whilst Keynesians argue that it can be in long-run equilibrium for years.
● On a Keynesian LRAS, the impact of changes in AD depend on where the economy is operating: if the economy is at full employment then a rise in AD will only lead to higher prices. However, if unemployment is very high, then a rise in AD will only lead to higher output.
● Both policies see significant time lags between their introduction and their full effect.
● The biggest issue of demand-side policies is that, in most cases, an expansionary policy is inflationary whilst a deflationary policy brings unemployment. This depends on the elasticity of the curve and the curve which you perceive to be correct (Keynesian or classical), but holds in most scenarios. Thus, through demand management, the government cannot bring about both low and stable inflation and high economic growth/low unemployment.
Monetary vs Fiscal policy
Monetary policy is useful as the government is able to increase demand without having to increase their spending, which would result in a larger fiscal deficit. Classicists argue that if demand management is going to be done only monetary policy should be used
Fiscal policy can have significant impacts on the supply side of the economy, for example increases in spending on education to increase AD will also increase LRAS. Moreover, it is more effective at targeting specific groups and reduce poverty, for example by increasing benefits it can increase AD and reduce inequality.
What is discretionary fiscal policy?
Where the government actively influences AD by changing its expenditure or taxes
What are automatic stabilisers?
Forms of government spending and taxation that changes automatically due to the stage of the economic cycle without any deliberate change in government policy
Limitations of monetary policy
- Time lag
- Banks may not adopt the change
- May not alter spending as people may be optimistic about the future
- Some countries have limited control over base rate
- Ultra low interest rates make expansionary monetary policy less flexible
- Proportion of people that are homeowners will influence the effect
- Pensioners incomes
- Inflation
- Other factors
Limitations of Fiscal Policy
- Speed of adjustment
- National debt
- Size of the multiplier
- Time lag
- Tax avoidance/evasion
- Inequalities
How the the yield of a bond calculated?
coupon / market price x 100
What is a bond?
A financial instrument issued by a government or business as a means of borrowing long term funds
What is the process of QE?
Central bank creates money
To buy bond from financial institutions
Which reduces interest rates
leading to people and businesses borrowing more
so they spend more and create jobs
to boost the economy
