Theme 4 CC9 - Role of the state in macro economy

Question 1

What are the types of public expenditure?

Answer 1

• Current expenditure
• Capital expenditure
• Transfer payments

Question 2

Define current expenditure

Answer 2

• Day-to-day expenditure on g&s e.g. teacher salaries, NHS spending

Question 3

Define capital expenditure

Answer 3

• Expenditure on long-term investment projects such as new roads/hospitals

Question 4

Define transfer payments

Answer 4

• Payments made by the state (from tax revenues) to individuals in the form of benefits where there is no production in return e.g. child benefits, jobseeker allowance.

Question 5

What are the benefits of increased public expenditure as a proportion of GDP on productivity and growth?

Answer 5

• Govt spending on education, healthcare and infrastructure can ^ productivity
• This will result in higher potential output and higher LR economic growth.

Question 6

What are the benefits of increased public expenditure as a proportion of GDP on living standards?

Answer 6

• Govt spending on education, healthcare and police can increase living standards in a society.
  -If individuals are better educated, they may have better career opportunites.
  -Living standards rise if individuals recieve treatment for illnesses and remain healthy.
  -Police raise living standards by reducing number of crime victims.

Question 7

What are the benefits of increased public expenditure as a proportion of GDP on Equality?

Answer 7

• Providing welfare benefits can help to raise incomes of the poor.
• Government spending on education can provide people with better career opportunities and a higher earnings potential.

Question 8

What are the problems of increased govt spending on taxes?

Answer 8

• High public spending may require high taxation to fund this. This may create dis-incentive to work and reduce LT economic growth.
• High taxes (withdrawal from circular flow of income) may also reduce AD and econ growth.

Question 9

What are the problems of increased govt spending on national debt?

Answer 9

• High public spending likely requires increased govt borrwing. This could add to national debt.
• Opportunity cost, could be spent elsewehre.

Question 10

Explain crowding out

Answer 10

If the economy is at full employment, producing at its max on PPF, then an increase in public sector spending will crowd out private sector spending.

Question 11

What are the types of crowding out and their disadvantages?

Answer 11

• Resource crowding out: occurs when the economy is operating at full capacity and an increase in public spending results in insufficient resources being available for the private sector.
• Financial crowding out: occurs when increased public expenditure or tax cuts are financed by public sector borrowing, so increasing the demand for govt bonds, raising the price and driving up interest rates. This reduces private sector investment due greater incentive to save and firms less likely to borrow to invest as it would be more expensive to pay back.

Question 12

Evaluate crowding out

Answer 12

• Resource crowding out may not occur if high unemployment
• Crowding in: if high unemployment then increased govt spending could lead to higher private sector spending through the multipler effect.
• Quantitative easing in the UK has kept interest rates low despite budget deficit. This is because BOE buys bonds which raises price and reduces interest rates.

Question 13

Explain impact of average income on the size of public expenditure

Impact on Composition (Where is it spent)?

Answer 13

• Increasing avg income: as incomes ^ over time, govt gain more tax revenue (income tax, VAT etc) therefore govts have more funds to spend on public services.

There may be more spending on health and education as demand increases. May be more spending on state pensions as govt is committed to raising state pensions in-line with avg incomes.

Question 14

Explain impact of Changing age distribution of population on the size of public expenditure

Impact on Composition (Where is it spent)?

Answer 14

• UK has an ageing population. This will mean there is more demand for govt spending over time.

More spending on state pensions
Greater demand for health/social care

Question 15

Explain impact of changing expectations on the size of public expenditure

Impact on Composition (Where is it spent)?

Answer 15

• As new medicines and health treatments are developed, individuals expect to have access to the latest treatment.
• More young people expect to go to university.
• More people expect to drive cars
  This will mean there is more demand for govt spending over time.

Greater demand for health care, higher education and new roads as expectations change over time.

Question 16

Explain impact of Economic shocks on the size of public expenditure

Impact on Composition (Where is it spent)?

Answer 16

• There was a big increase in public spending following financial crisis, covid pandemic and cost of living crisis.

Financial crisis= govt spent money lending to banks and buying shares to prevent them colapsing
COVID = Furlough schemes to keep people in employment
Cost of living= Subsidised energy bills for households/businesses following Ukraine War and rise in energy prices.

Question 17

What is the difference between Direct and indirect taxes

Answer 17

• Direct taxation is levied on income, wealth and profit e.g. income tax, national insurance, corp tax
• Indirect taxes are imposed on producers, passed onto consumers through higher prices on G&S

Question 18

What is the difference between progressive, regressive and proportional taxes?

Answer 18

Proggressive = as income rises, a larger percentage of income is paid in tax
Proportional = percentage of income paid in tax is constant
Regressive = as income rises, a smaller percentage of income is paid in tax e.g. excise duties on alcohol, tobacco, betting etc.

Question 19

What is the effect on a cut in income tax?

Give evaluation

Answer 19

SR: AD will rise as workers will have greater disposable incomes, leading to greater consumer spending and a multiplier effect.
LR: Reduced income tax increases incentive to work, ^AS as size of workforce/productivity increases.
Show on AD/AS diagram

E: Depends how much personal allowance rises by (size of tax cut) will determine significance of effect.
Also, there is weak evidence to support a greater incentive to work as people can work less hours for same income

Question 20

Explain the laffer curve

Answer 20

A (n shaped) curve which shows that at low levels of taxation, tax revenues will increase if tax rates are increased. However, if tax rates are high, then a further rise in rates will reduce total tax revenues because of the disincentives of the increase in tax

Question 21

What factors may cause a decrease in tax revenues if taxation is too high?

Answer 21

• Increased disincentives to work
• Increased tax avoidance/evasion
• A rise in tax exiles and firms moving elsewhere

Question 22

What is the effect of a rise in corporation tax?

Evaluate

Answer 22

If corp tax ^, retained profits fall (70% of investment therefore) investment falls.
SR: AD falls due to less investment
LR: AS falls, capital depreciates, therefore less investment means less capital is replaced resulting in a fall in productivity and factors of production.
Show on AD/AS diagram

E: Impact depends on corporation tax in UK relative to other countries.
Most significant factor affecting investment is business confidence
If UK economy begins to grow, businesses could invest more.

Question 23

What is the effect of a rise in VAT e.g. from 17.5% to 20%

Evaluate

Answer 23

• If VAT^, businesses will pass on higher prices to consumers. As they have to sort this tax out and pay it to government, AS falls. Price level rises and real GDP falls. AD doesn’t shift as it is just a contraction of demand due to higher price.
  Show on AD/AS

E: Raising VAT is regressive - poor pay a higher % of their income in VAT than rich do
- Adds to cost push inflation
- Effect on consumption depends on PED
- If ad curve=inelastic then there would be a relatively large rise in price level and small effect on GDP.

Question 24

What are the problems of increasing tax as a % of GDP?

Answer 24

Lower disposable incomes, lower living standards.
Less consumption & investment, less incentives to work hard, take risks, innovate, study etc

Question 25

What is the link between govt borrowing and a fall in GDP

Answer 25

- Govts choose to spend more to support economy e.g. multiplier effect - GDP falls so deficit as a % of GDP rises, therefore requires more borrowing to pay off debt

Question 26

What are automatic stabilisers?

Answer 26

A process by which govt expenditure and tax revenue varies with the busines cycle, thereby helping to stabilise the economy without any conscious intervention from government.

Question 27

Explain the effect of automatic stabilisers on fiscal policy when GDP falls (i.e. recession) And what effect does this have on recession

Answer 27

1. As GDP falls, Tax revenues fall as incomes, consumption and profit falls. 2. Govt spending on benefits ^ as unemployment ^ and incomes fall. -This will happen even if govt do not adjust spending plans/tax rates. Therefore, AD^ and GDP^ as there is greater injection from govt spending and a smaller withdrawal from taxation.

Question 28

Define discretionary fiscal policy

Answer 28

The deliberate manipulation of govt expenditure and taxes to influence the economy.

Question 29

Define contractionery fiscal policy

Answer 29

Used to reduce AD by increasing tax and/or reducing govt spending

Question 30

Explain tax receipts

Answer 30

Govt can use difference of budget surplus to repay part of national debt

Question 31

Explain fiscal austerity

Answer 31

Tax rises or govt spending cuts designed to reduce a govt budget defecit

Question 32

What is the difference a between cyclical and structural defecit?

Answer 32

Cyclical: that part of the fiscal deficit which is caused by govt spending and taxes changing through the trade cycle (automatic) Structural: that part of a fiscal deficit that exists even when the cyclical deficit is zero at the top of a boom (therefore govt still running budget deficit in boom, more of a serious problem than cyclical).

Question 33

Give p1 Problems of high budget deficits/high naitonal debt with evaluation

Answer 33

Financial crowding out: - This is where increased government borrowing reduces private sector investment. If the government needs to borrow more they will need to offer higher interest rates to bondholders to persuade them to lend to the government. If the government offers higher rates of interest then banks will also have to offer higher rates of interest to savers to attract savings (as an alternative to investing in govt bonds) and will charge higher rates of interest to borrowers (to be able to make a profit). This will reduce investment as there are less projects that would be profitable with higher costs to borrow. Furthermore, businesses more likely to save profits rather than invest due to a greater return with higher interest rates. SHOW ON DIAGRAM: AD falls due to less investment, consumption etc, AS falls in LR due to less investment, fall in econ growth. Effect on international competitiveness, ^unit labour costs due to less investment into innovation to create more productive production methods. E: Effects depend on state of economy, if large output gap, increased govt spending from fiscal deficit may lead to a net resource crowding in of private sector as govt spending represents an injection into economy, having a multipier effect on demand for private sector goods. One persons spending is another persons income. This incentivises private sector firms to raise own levels of capital investment and employment. - Private sector investment more dependent on business confidence (as seen by covid, brexit,cost of living) rather than interest rates. - QE by BOE reduce interest rate on govt bonds by creating new money and using this to buy bonds.

Question 34

Give p2 problems of high budget deficit/national debts with evaluation

Answer 34

-Opportunity cost of increased debt repayments - Governments borrow money by selling bonds. Bondholders receive rate of return on these assets, therefore if govts run large budget deficits than more money must be paid on interest. E.g. UK now pays more money in debt interest than defence. Opportunity cost as govts could be spending this money on public services such as health/education. Also govt cannot reduce taxes which passes on burden to next generation who will pay off debt in their taxes. -Furthermore, if govts run high budget deficit, bondholders may lose confidence in govts ability to repay loans. Therefore less willing to lend money, fall in demand for govt bonds, price falls and interest rates rise as bondholders receive fixed payments, worsening the debt. E: Could be argued debt is essential for econ growth and the opportunity cost of debt repayments is irrelevant as govts have to pay interest anyway to borrow to be able to support economy in crisis such as covid. Also depends on the size of fiscal deficit and the rate of economic growth, as to how confident bondholders are that govts will pay them back. Also depends on if country has own currency and control over monetary policy

Question 35

Give p3 problem of high national debt/Evaluation for budget deficit

Answer 35

Reasons not to reduce budget deficit quickly/problem of high national debt - Fiscal austerity implemented which results in smaller net injection on circular flow of income as Govt spending (falling)=injection and taxation (rising) = withdrawal. Therefore AD falls which may cause negative multiplier effect if the government cuts spending as this reduces income to public sector workers who may lose their jobs or to organisations that provide services to the public sector. These people then have less income to spend in the economy. The eventual fall in national income is more than the cut in government spending. If there is lower national income (Consumption, income, profits) this will reduce tax revenue. If there is higher unemployment this will mean the government must spend more on benefits. This means the government needs to borrow more, opposing the initial objective of reducing budget deficit. - Therefore may lead to a Fall in living standards, govt spending cut on goods with positive externalities e.g. education - reduces LRAS as productive potential falls. E: The effect of deficit reductions depends upon the state of the economy If growth in the private sector offsets the fall in the size of the public sector then output, income and employment will rise.

Question 36

Give 3 effects of Contractionary Monetary policy

Answer 36

1. Less consumption - More incentive to save, cost of borrowing rises, variable rate mortgages rises, less disposable incomes. 2. Less investment - increased cost of borrowing, less profitable investments, greater incentive to save, higher rate of return. 3. Rise in the value of £ - high interest rates will attract saving/hot money to UK banks. Increasing demand for pound, ^value causing export prices to rise (demand for x falls), import prices falls (^demand). Worsening current account balance. - Growth of AD and inflation falls as consumption falls, investment falls and net exports falls.

Question 37

Evaluate monetary policy

Answer 37

- Depends on size of output gap (expansionary could cause demand pull inflation) - Depdns on level of change in interest rates - Depends on consumer and business confidence - Depends on banks willingness to lend - Time lag - (Expansionary) Negative impact on savers

Question 38

What is QE and the aim? Give example

Answer 38

BOE electronically prints money and uses this to purchase assets in the economy. - Aim is to increase AD to keep inflation at 2% - BOE purchased £895bn of bonds since financial crisis and £875 bn of thios used for govt bonds.

Question 39

Give 3 effects of QE

Answer 39

1. Higher prices of other assets - as BOE buys bonds the price of bonds ^ and interest rate on the bond falls. Therefore, investors may look to buy other assets instead. This causes a rise in demand for shares and rise in the value of shares in the stock market. This increases wealth causing a positive wealth effect. This increases consumption as shareholders are more confident and some individuals may sell shares for a profit and spend more. 2. Lower LT interest rates - if BOE buys govt bonds, the price of bonds ^ and the interest rate on bonds fall. This will decrease LT market interest rates as the commercial banks will be able to offer lower interest rates to savers due to less comp for savings from government. This also means lower interest rates for borrowers. Therefore less incentive to save/lower variable rate mortgages= increased consumption. Cheaper to borrow=more investment . 3. Reduced value of the £ - If increase in money supply, this is likely to reduce interest rates. Increasing consumption/investment and AD. Also causes hot money outflows due to relatively lower interest rate, less incentive to save with low return, less demand for £, more supply of £, decrease in value. This makes exports cheaper (increasing demand) and imports dearer (fall in demand), therefore improving current account.

Question 40

Evaluate QE

Answer 40

1. QE is damaging to pensioners and savers, it has hampered their spending power - QE has reduced the interest rates on savings accounts and reduced the incomes for pensioners and other individuals who rely on interest as an important source of income. Real interest rates are -ve as inflation rate> interest rate. 2. QE ^Inequality - QE has caused a rise in asset prices such as shares and houses. This has increased wealth inequality as the rich tend to own shares and valuable properties, but the poor do not. 3. Large rise in Share price is unsustainable - Share prices will inevitably crash in the long-run (market bubble) and this causes a negative wealth effect which reduces AD and GDP.

Question 41

Give examples of macro policies in different countries - Austerity -Inequality and poverty

Answer 41

- Post financial crisis Eu govts introduced austerity measures to reduce their budget deficits. This meant cutting govt spending and raise taxes e.g. Germany ran budget surplus in recent years, Greece forced to cut spending and raise taxes for bailout loans. - Braxil govt introduced welfare programme 'Bolsa Familia' which helped to reduce poverty in brazil.

Question 42

Give examples of macro policies to respond to external shocks to the global economy

Answer 42

Governments around the world have used fiscal policy to support their economies following the Coronavirus pandemic. For example, the French government has offered loans to businesses to prevent them from becoming insolvent. Following the Financial crisis of 2008-9 the American and Chinese governments increased borrowing to finance new infrastructure projects and increase output and employment through the multiplier effect. Central banks around the world have responded to the Coronavirus pandemic. For example, the US central bank, the Federal Reserve cut interest rates to try to increase output and employment.

Question 43

Give measures to control global companies (TNCS)

Answer 43

TNCs use tax avoidance such as transfer pricing to lower tax paid. In the UK, companies which don’t allocate sufficient profits here are challenged by HMRC and this has led to billions of pounds earnt in taxes. However it is difficult to impose regulations or taxes on MNCs as they can move to another country e.g. Starbucks claiming profit in Swiss subsidiaries (low corp tax). - This prevents govts from making laws to protect workers rights, the environment or from regulating banks. Leads to exploitation of workers.

Question 44

What are the problems for policymakers when applying policies

Answer 44

It is always difficult for governments to implement fiscal policy and it is difficult for central banks to implement monetary policy. This is because the economic data used to make decisions could be inaccurate and out of date. For example, GDP figures are an estimate of the total output of an economy but it is quite challenging to measure the output of all the businesses and public sector organisations. The figures are usually revised several times as more information becomes available. Therefore, policy makers may be using statistics that are out of date. They may not realise the economy has fallen into a recession or they may not realise the depth of the recession. Therefore, the policy response may be too slow and too weak to prevent a deep recession.