Theme 2 Topic 6 Flashcards
What are the 4 key objectives used to measure national economic performance and form the basis of the government’s macro economic policy objectives ?
- Economic growth
- Low unemployment
- Low and stable inflation
- Balance of payments
economic growth (objective)
measures rate of change of a country’s output.
key measure is GDP.
in the UK, the long run trend of economic growth is 2.5%.
governments aim to have sustainable economic growth in the long run.
in developing countries, the governments may aim to increase economic development before economic growth.
this would improve living standards, increase life expectancy and improve literacy rates.
low unemployment (objective)
high unemployment means poor economic performance.
economies that have strong economic growth have low unemployment.
govern,ents aim to have as near as full employment as possible.
they account for frictional unemployment by aiming for an unemployment rate of around 3%.
the labour force should be employed in productive work.
low + stable inflation (objective)
The inflation target has been made independent of the UK government to give a key component of macroeconomic policy more credibility.
Government target is 2% for the UK (measured by CPI).
it 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% (+ or -) outside the target, the governor of the BoE has to write a letter to the chancellor of exchequer to explain why this has happened and what the Bank intends to do about it.
balance of payments (objective)
Given that deficits have to be funded (often by borrowing) it is assumed that a surplus or equilibrium on the current account is the desired objective.
It’s is important to allow the country to sustainably finance the current account, which is important for long term growth.
The UK economy is heavily skewed towards the tertiary sector, which is a key driver of jobs and income.
It’s viewed by many economists that a deficit overall may not be detrimental to the wider economy.
Consumers have a wider choice of goods (higher quality + lower prices), increasing standards of living and welfare.
Producers can benefit from cheaper + higher quality raw materials which reduce costs.
How can the government achieve their objectives ?
Governments are able to manage demand through monetary + fiscal policy.
Recession = increase AD to increase employment + economic growth.
Boom = decrease AD to decrease inflation.
They may also use supply side policies to cause long term growth.
Emphasis on each individual government objective changes over time so the current government will focus on :
- A balanced government budget
- Protection of the environment
- Greater income equality
Balanced government budget (objective)
Government revenue = government expenditure
No budget surplus (revenue > expenditure)
No budget deficit (revenue < expenditure)
Ensures the government keeps control of state borrowing, so the national debt doesn’t escalate.
Allows governments to borrow cheaply in the future should they need to and make repayments easier.
Protection of the environment (objective)
Aims to provide long run environmental sustainability.
Ensures resources used aren’t exploited (e.g. oil and natural gas), and that they are used sustainably so future generations can access them too.
Avoids excessive pollution.
May involve supporting businesses through the form of investment grants.
Greater income equality (objective)
Minimises the gap between rich + poor.
Associated with a fairer society.
Extreme income inequality is seen as socially unacceptable.
Society believes all citizens should be able to access fair wages for a fair day’s work.
Many studies suggest that increasing income equality causes higher levels of economic growth + better standards of living and a happier overall society.
What are demand side policies ?
Demand side policies are policies designed to manipulate consumer demand.
Expansionary policy is aimed at increasing AD to bring about growth.
Deflationary policy attempts to decrease AD to control inflation.
What is the monetary policy ?
Managed by the Bank of England. Controls inflation and AD using interest rates and QE.
Used to influence the level of economic activity.
What is the fiscal policy ?
Managed by the government. Changes tax and spending to influence AD.
2 types of monetary policy instruments :
- Interest rates
- Quantitative easing
A rise in interest rates causes a fall in AD through 4 mechanisms
- Fall in investment + consumption
- Negative wealth effect
- Decreased consumer + business confidence
- Impacts on exchange rates + net trade
Negative wealth effect
Higher interest rates reduce the value of assets (stocks, shares, government bonds) due to lower demand.
Consumers experience a negative wealth effect, leading to a fall in consumption.
Firms’ investment becomes less attractive as falling asset prices reduce expected profits.
Decreased consumer and business confidence
Higher interest rates lower confidence in borrowing and spending.
Fall in consumer and business confidence leads to reduced consumption and investment, further decreasing AD.
Impact on exchange rates and net trade
Higher interest rates attract foreign capital due to higher returns.
Increased demand for pounds causes the currency to appreciate.
Stronger pound makes imports cheaper and exports more expensive, reducing net trade and AD.
positive effects of QE on the economy
- Positive wealth effect
- Increased money supply
- Lower commercial bank interest rates
Positive wealth effect (QE advantage)
Bank buys assets, increasing demand and causing asset prices (e.g., shares, houses) to rise.
Wealth effect: As asset values rise, people feel wealthier and increase consumption.
Lower Borrowing Costs: Higher asset prices reduce yields (returns on assets), making borrowing cheaper for households and businesses.
Increased money supply (QE advantage)
More money enters the economy as private sector companies receive funds, which they can spend on goods, services, or financial assets.
This can increase consumption and investment, boosting aggregate demand (AD).
Higher reserves in banks enable more lending, increasing both consumption and investment through credit.
Lower commercial bank interest rates (QE advantage)
Banks receive more money from the Bank of England, allowing them to offer lower interest rates to customers.
Lower interest rates reduce the cost of borrowing, encouraging more borrowing, investment, and consumption, thus increasing AD.
If many banks lower their interest rates, similar effects are seen as when the base rate is reduced.
Problems with QE :
- It is very risky and, if not controlled properly, could cause high inflation and even hyperinflation.
- There is no guarantee that higher asset prices lead into higher consumption through the wealth effect, especially if confidence remains low.
- It was not meant to be permanent and there are concerns that banks and economies are too dependent on QE, particularly within the Eurozone.
How effective is the monetary policy ?
- Size of Interest Rate Changes: The impact of monetary policy depends on how large the interest rate changes are.
- Timing of Rate Changes: The effectiveness depends on when the changes are made in relation to the economic cycle.
- Stage of the Economic Cycle: The effectiveness varies depending on whether the economy is in a boom, recession, or stagnation.
- Inflation Control: The primary target of monetary policy is inflation control, but it may conflict with other objectives like economic growth.
Link between interest rates and exchange rates
Global investors seek the best return, so they move money to countries with higher interest rates.
If the UK raises interest rates, investors will move their money to the UK, increasing demand for UK pounds.
This increases the exchange rate, making UK exports more expensive and imports cheaper.
As a result, the balance of payments on the current account worsens.
This is called Hot Money, as funds move globally in search of the best interest rates.
Difference between budget deficit and surplus ?
-
Budget Deficit:
- Occurs when the government spends more than it receives (through taxes and other revenues).
- Leads to increased government debt that must be repaid in future years.
-
Budget Surplus:
- Occurs when the government receives more than it spends.
- Allows the government to reduce its debt burden and lower interest payments.
What is the difference between direct and indirect taxes?
Direct Taxes:
Paid directly to the government by the individual taxpayer.
Examples: Income tax, National insurance, Corporation tax.
Indirect Taxes:
The person charged with the tax (e.g., supplier) can pass on the cost to someone else (e.g., consumer).
Examples: VAT, Excise duties, Council tax, Capital gains tax, Inheritance taxes, Stamp duty land tax.
What are the key issues when evaluating demand side policies
Classical vs Keynesian Debate:
Classical economists argue that demand management policies (fiscal and monetary) will not affect long-run output, only prices. They believe the economy naturally returns to equilibrium.
Keynesians disagree, arguing that the economy can remain in disequilibrium for a long time, and demand-side policies can help boost output and reduce unemployment in the short-to-medium term.
Impact Depends on Economic Conditions:
Keynesians: At full employment, a rise in AD will increase prices (inflation) rather than output.
In times of high unemployment, boosting AD can lead to higher output without causing inflation, especially if there is spare capacity in the economy.
Monetary vs fiscal
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 LAS.
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 stagflation ?
when an economy experiences both high inflation and high unemployment at the same time.
What are the monetary policy goals ?
- Primary target : low inflation rate (2%) (+1/-1)
- Managed by the BoE and controls inflation and AD.
Monetary policy committee
Responsibility of the MPC is to set interest rates.
9 members
4 independent
5 from within the bank.
Chaired by the Governor of the BoE = Andrew Bailey
Meets monthly to assess the state of the economy + decide whether they should increase or decrease interest rates from their existing level.
Independent from the government, giving it more credibility (free from political influence).
Interest rates :
Cost of borrowing and reward of saving (price of money).
High rates : decrease borrowing and increase spending, lowering AD
Quantitative easing
2008 recession: BoE would have expected to cut interest rates to help stimulate economic activity.
However, rates were already at 0.5% so couldn’t decrease further.
Banks were nervous to lend money so £375 bn was raised in QE to boost funds to lend.
QE process
- Central bank creates digital money (not printed)
- It goes to banks + buys off bonds, the banks get money.
- Increases the bank’s money supply
- Banks lend more, so interest rates fall
- Cheaper loans means more spending
- Binds mature and are replayed over time
Expansionary fiscal policy
Trying to increase economic activity + AD.
- Cutting taxes (withdrawal in CFI):
decrease income tax, increases disposable income, increases consumption.
decrease corporation tax, increases available profits for firms, increases investment. - raises government spending:
government increase spending on core infrastructure projects or increase the pay of public sector workers (injection). more jobs for infrastructure workers and higher pay for public workers. increases consumer incomes and feeds through the CFI.
contractionary fiscal policy
trying to decrease AD, debt, and control inflation.
1. increasing taxes :
increases income tax, discourages spending and consumption.
decreases the level of AD + keeps inflation under control.
- cutting government spending :
the government can decrease expenditure on public projects or cut government budgets if it considers excess government spending to be inflationary.
benefits BoP as less income spent on imports.
however, this reduces RNO so damages economic growth.
falling consumption and less AD means increases cyclical unemployment.
national debt
total amount of money owed by the government
limitations of fiscal policy
takes a long time before it affects output or employment.
has some built in trade offs
- expansionary : higher output and lower unemployment.
causes higher inflation and worsens BoP.
- contractionary : controls inflation
causes higher unemployment and damages GDP
Great Depression (1930s)
demand collapsed, unemployment soared.
US initially used laissez faire, later used large public works (New Deal).
Keynes argued government spending should rise in recessions.
Global financial crisis (2008)
caused by financial sector collapse and housing bubble.
US/UK response : cut interest rates to near 0%.
massive QE.
large fiscal stimulus (e.g. UK car scrappage scheme + US stimulus packages).
critics argued this caused higher debt.
demand side policies advantages (4)
lowers unemployment fast.
stimulates growth in a recession
fiscal good for targeting
monetary policy flexible
demand side policies disadvantages (4)
causes inflation if used too much
time lags (takes time to see full effects)
increases budget deficit
QE causes asset bubbles or weakens the currency
multiplier effect
creates a virtuous cycle of spending and income
causes a greater overall impact on the economy
it can increase LRAS
tax cuts may incentivise work + increase the labour force
investment increases quantity and quality of capital
government spending on education and infrastructure improves productivity
drawbacks of expansionary monetary policy (1)
- potential risk of lowering interest rates.
demand pull inflation
widens current account deficit
interest rates have a lower bound (liquidity traps)
negatively impacts savers.
drawbacks of expansionary monetary policy (2)
- effects on savers and borrowing
lower returns on savings accounts
returns can become negative if inflation exceeds interest rates.
incentivises borrowing over saving
reduces financial safety nets for households
drawbacks of expansionary monetary policy (3)
- time lags and effectiveness
full effects take 18-24 months in the UK
effectiveness depends on size of output gap
consumer + business confidence is crucial
banks must be willing to lend
supply side policies
policies that seek to improve the long run productive potential of the economy.
successful policy shifts a country’s PPF to the right
what are free market policies
allows the free market to operate, with the government reducing its role in the market.
encourages the private sector to be more efficient.
what are interventionist policies
involved government intervention to tackle market failure
types of free market policies
- reduces income tax (creates incentives for people to work harder, leading to more output). however, lower taxes don’t always increase work incentives.
- reduces power of trade unions (increases efficiency of firms due to less time lost in strikes, and reduces unemployment if labour markets are competitive)
- promotes competition
deregulation (opening markets to freer competition and removing barriers to entry should help to increase productivity gains and boost supply)
privatisation (minimise state control can be inefficient, yet it has been pursued by governments to privatise key areas of the economy to drive efficiency)
types of interventionist policies
- improves skills and quality of labour force (training and education, improves productivity, mobility, and flexibility of the workforce)
- improves infrastructure
transport network (improves speed of connections e.g. rail, road)
provision of information (ensures access to fast information e.g. broadband)
supply side policies disadvantages (3)
- expensive + time lags (in terms of effectiveness) (training and education take several years for the full effects to be felt)
- may not help in a deep recession (AD is needed)
- effects are uncertain and uneven
supply side policies advantages (4)
- lower inflation (makes economy more efficient, policies reduce cost push inflation)
- reduces unemployment (reduces structural unemployment + helps reduce the natural rate of unemployment)
- improved economic growth (increase the sustainable rate of economic growth by increasing AS)
- improves BoP and trade (makes firms more productive + competitive so exports rise)
Conflicts between objectives
Growth vs Inflation: fast growth can cause inflation.
Low unemployment vs Inflation: Phillips curve shows a trade-off.
Environmental protection vs Growth: stricter rules may reduce output.
Equality vs Efficiency: redistributing income may reduce work incentives.
+ fall in interest rates negatively impacts savers. they are more wealthy so there is some redistribution of income. however, lower rates cause inflation (higher spending)
Short run Phillips curve
Shows inverse relationship between inflation and unemployment.
As AD increases, inflation rises but unemployment falls In the long-run, curve is vertical (no trade-off).
When unemployment is low, inflation tends to be high because workers demand higher wages, which pushes up prices.
When unemployment is high, inflation tends to be low as wage pressures are weaker.
This reflects demand-side relationships.
BUT - in the 1970s, this broke down (e.g., stagflation: high unemployment + high inflation).
Shows a potential conflict between objectives: reducing unemployment might cause inflation to rise
expansionary vs deflationary (trade off)
Expansionary Policies: Increase AD, boosting growth and employment but causing inflation and worsening the balance of payments due to more imports.
Deflationarv Policies: Reduce AD to control inflation but lower growth and increase unemplovment.
Trade-Off: Expansionary policies stimulate growth but risk inflation; deflationary policies control inflation but harm short-term arowth.
supply side policies (trade off)
Goal: Increase long-term growth and reduce inflation.
Trade-Offs: May raise AD in the short term, causing inflation. Policies like cutting benefits may increase income inequality.
Trade-Off: Boosts growth long-term but mav harm low-income groups in the short term.
interest rates (trade off)
Raising Interest Rates: Controls inflation but discourages investment, reduces exports (stronger currency), and increases income inequality (benefits savers, harms borrowers).
Trade-Off: Higher rates control inflation but slow growth and worsen inequality.
fiscal deficit (trade off)
Reducing Deficits: Involves cutting spending and raising taxes, which reduces AD, slows growth, and increases unemplovment.
•Trade-Off: Deficit reduction hurts short-term growth, especially for low-income people who rely on government services.
Trade-Off: Necessary for long-term stability but harms short-term growth and equality.
