Theme 4.5.4 Flashcards
What macro-economic policies can the government use to achieve goals?
-Fiscal policy
-Monetary policy
-Supply side policy
-Exchange rate policy
-Direct controls
What are direct controls?
A government measure that is imposed on the price of the quantity of a single product or factor of production.
Examples include: minimum or maximum prices/wages, quotas on imports, limits on currency or regulation e.g. maximum interest rates.
What policies can the government use to reduce fiscal deficits and national debts?
-Policy of austerity (increasing taxes and reducing spending)
-Stimulate demand via high gov spending
-Rely on automatic stabilisers
-Default on loans
How can austerity be used to reduce fiscal deficit and national debts?
-To decrease the national debt, the UK government has been using a policy of austerity since 2010, where they attempt to decrease spending. It would also be possible to increase taxes.
-Both of these are unpopular, could limit growth, and reduce living standards and income equality.
-Free market economists say that spending can be reduced by cutting out waste, but it is highly unlikely that these efficiency savings will make a significant difference.
How could demand stimulus by high spending reduce fiscal deficits and national debt?
This will cause economic growth and therefore bring about higher tax revenues. This will allow for budget surpluses and eventually a reduction of national debt.
How can reliance on automatic stabilisers reduce fiscal deficit and national debt?
Another approach is to simply rely on automatic stabilisers to allow the economy to grow so national debt/fiscal deficit will reduce as a percentage of GDP. This is mainly the approach that the US took after the Global Financial Crisis and their economy recovered fairly quickly. By 2015, the fiscal deficit as a percentage of GDP was similar in the US and UK.
How can defaulting on loans reduce fiscal deficit and national debts?
One way to reduce national debt would be for the government to default on their loans but the economic cost of this is so large that governments only default if it is the only option. Russia and Argentina have defaulted on their debts in the past.
What government policies can be used to reduce poverty and inequality?
-Income redistribution
-Progressive tax systems
-Government provision of some goods and services
-Minimum wages
-Trade Union-friendly legislation
-Enforcing the payment of benefits to workers from employers
-Improve education and training
-Price controls
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Why is income redistribution important in an economy?
-The law of diminishing marginal utility suggests that redistribution increases total utility and therefore is a better allocation of resources. The higher the spending of an individual, the less satisfaction they gained from spending an extra pound. The high growth rates of Nordic countries, like Denmark, where redistribution is high suggests that it is not negative for economic growth.
-However, too much redistribution could disincentivise and cause the poverty trap.
How can income redistribution be used to reduce poverty and inequality?
Free market forces are unlikely to create an equal society, leading to absolute or relative poverty and inequality. Most agree that some redistribution from rich to poor is necessary, but the degree to which it is done is contentious. Those on the right argue that high incomes and profits are essential to provide an incentive, whilst those on the left argue that those on low incomes need to be supported.
How can a progressive tax system reduce poverty and inequality?
-Firstly, the government can use a progressive tax system which will produce a more equal distribution of income after tax. Inheritance taxes mean that wealth inequality will be reduced as less money can be passed on to the next generation.
-The USA has a progressive tax system but the welfare system is not effective at redistributing income. In countries such as Finland and Scandinavia, the tax system is less progressive but the government collects a lot of tax revenue which they are effective at redistributing.
How can benefits and transfer payments reduce poverty and inequality?
-Social security and National Insurance benefits now represent 30% of government spending in the UK.
-Universal benefits are available to everyone who meet certain criteria, respective of personal income e.g. winter fuel allowance, child benefits.
-Means tested benefits are only available to people who have sufficiently low levels of income/wealth. They are targeted at people who need the most help and provide a safety net/minimum standard of living and are better at improving inequality since they directly affect the poor.
How can the government provide goods and services to reduce inequality and poverty?
The government can also provide goods and services which give citizens equal opportunities and access to services they may not otherwise be able to afford, such as healthcare, education and housing. This helps to ensure that everyone is given an equal start in life, for example poor children do not lose out because their parents are unable to afford education. The problem with these is that they also benefit those on higher incomes and incur a high opportunity cost. In the UK, the government provides free healthcare, but this is not the case in many countries.
How can the government attempt to reduce wage differentials to reduce poverty and inequality?
-A national minimum wage will improve the incomes of the poor whilst maximum wages or pay ratios will reduce the incomes of the rich and could even mean companies increase the pay of their lowest income workers. However, minimum wages may cause unemployment and maximum wages may lead to a loss of the most skilled workers.
-Equal pay legislation will prevent inequality between men and women or between different ethnic groups.
-Trade union friendly legislation will allow the wages of their workers to rise,
and those in unions are more likely to be the low paid so this will positively
affect equality .
-Employers could be forced to provide benefits to their workers, such as sickness benefits, pensions and medical care, which will effectively increase wages.
How can the government improve access to education and training opportunities to reduce inequality and poverty?
-Improvements in access to education and training opportunities will prevent children from poorer backgrounds achieving less than others, which would reduce their earning potential.
-The government has attempted to address this by offering additional funding through the pupil premium scheme and easier access to universities, for example lower grades for those in certain areas,
How can the government use price controls in order to reduce inequality and poverty?
-They could introduce price controls on essential goods, such as housing, bus fares, bread, electricity etc. This will increase the spending power of the poor.
-However, this could cause excess supply and may lead to the development of black markets.
Why may the central bank change interest rates and the money supply?
-The central bank has the ability to change interest rates and monetary supply.
-They may do this for domestic reasons, such as to control inflation, or due to global issues such as a low exchange rate or a change in world commodity prices.
-A fall in the bank rate is likely to increase the supply of money because it will mean there is more demand for loans.
Why is it argued that central banks don’t have complete control over the money supply?
There is no simple relationship between the supply of money and inflation and it can be argued that central banks don’t have complete control over the money supply because they cannot control the ability of the financial system to create credit. The globalisation of the financial market has also made it increasingly harder to control domestic money supply.
What is an example of the Bank of England using quantitative easing in the UK?
Following the financial crisis of 2007-08, some central banks were concerned with deflation rather than inflation and this led to the policy of quantitative easing. For example, the Bank of England and the European Central Bank used this policy. This is because interest rates were so low they could not be reduced much further, and low consumer and business confidence had not caused consumption to rise as hoped.
Why were low interest rates ineffective following the financial crisis in the UK?
-Banks didn’t have money to lend. (Poor liquidity) Therefore, unwilling to lend.
-Confidence was very low, due to the banking crisis. Consumers and firms were unwilling to take the risk of higher borrowing and investment due to the severe crisis.
-Time lags. Cutting interest rates can take up to 24 months to have an effect e.g. people on fixed rate mortgages don’t notice straightaway.
-Fiscal policy was tight, with governments pursuing austerity measures to reduce budget deficits so negating benefit of rate changes.
What are some measures to increase international competitiveness?
-Currency devaluation
-Internal devaluation
-Measures to increase occupational mobility (eg education and training schemes)
-Macroeconomic stability (low and stable inflation, sound public finances etc)
-Reduce red tape
-Improve infrastructure
-Privatisation
-Incentives for private business investment (eg tax breaks and subsidies).
How can supply side measures help to increase international competitiveness?
-Supply side measures will improve productivity and flexibility and can involve taxes and deregulation.
-They can encourage competition, forcing firms to be efficient and thus competitive within the global market.
-They can place an emphasis on quality of products and use tax incentives to encourage incentives.
-Education will improve the skills of the workforce and help improve flexibility.
-The UK government has established the ‘Red Tape Challenge’, which aims to simplify regulation for businesses.
How can a government use devaluation to increase international competitiveness?
-Iceland
-This increased the cost of imports, increased inflation and reduced living standards.
-However, it did help to make exports more competitive and to rebalance the economy away from finance sector.
How can internal devaluation increase international competitiveness?
-Countries in the Eurozone were not able to devalue. Therefore, they had to use other policies to improve competitiveness. This included:
-Supply side reforms to improve productivity and competitiveness e.g. privatisation and deregulation of markets.
-Tight fiscal policy, to reduce inflationary pressures.
-Lower wages of public sector, to try and reduce wages
What issues can internal devaluation cause?
-Time-lag: It can take a long time to improve competitiveness through relying on deflationary fiscal policy.
-Resistance to wage cuts. Many workers are resistant to cuts in nominal wages .
-May also cause deflation, which can have many negative impacts on the economy.
What negative impacts can TNCs bring to an economy?
-They can have a negative economic and social impact by destroying local culture, affecting the environment and withdrawing more in profits than they inject through investment.
-They also have a history of influencing politicians to take decisions that will favour their interests and are involved in tax avoidance.
-In the EU and the USA, it is illegal for TNCs operating in their country to use bribery or corrupt practices anywhere in the world and they can be fined for doing so.
How do some developing countries prevent the TNCs negatively impacting their economies?
Some developing countries don’t allow TNCs to set up in their country without first setting up a joint company with a local partner, meaning that some profits are retained within the country and knowledge/technology is transferred. Many governments use import contracts with TNCs, meaning that at least some part of the value of the order must be manufactured in the country.
What is transfer pricing?
● Transfer pricing is one way for firms to engage in tax avoidance. This can occur if a firm produces a good in one country and then transfers it to another to make it into another good which it then sells.
● If taxes are higher in the first country than the second country, they can set a low price on the product made in the first country. The overall aim is to increase their profit made in the low tax country and decrease it in the high tax country and so overall reduce their tax bill.
How is transfer pricing regulated against?
● 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.
● The Transfer Pricing Guidelines were introduced by the OECD in 1995, providing guidelines on cross-border services, intangibles, cost contribution arrangements and advance pricing guidelines; these were modified in 2010. They aim for the price to be the same as if the two parties were independent of each other; the ‘arm’s length’ principle.
What is an example of transfer pricing?
● The EU suffers from legal tax avoidance schemes, such as the ‘Dutch sandwich’ and the ‘double Irish’, where costs, revenues and profits are routed through Ireland, the Netherlands or Luxemburg and then sent to a tax haven like the Bahamas or the Cayman Islands. It is suggested that for every £1 gained in extra taxes by Luxemburg, other countries are collectively losing possibly £1000 in tax revenues.
How is transfer pricing experienced in the EU?
● The EU suffers from legal tax avoidance schemes, such as the ‘Dutch sandwich’ and the ‘double Irish’, where costs, revenues and profits are routed through Ireland, the Netherlands or Luxemburg and then sent to a tax haven like the Bahamas or the Cayman Islands. It is suggested that for every £1 gained in extra taxes by Luxemburg, other countries are collectively losing possibly £1000 in tax revenues.
Why are solutions to transfer pricing extremely difficult to solve?
-Solutions to taxation are extremely difficult as they require worldwide agreement. However, any solution which would benefit a country like the UK would lead to great losses for countries like the Bahamas, Ireland and Luxembourg.
-There is also division within countries, for example in the USA between the Democrats and Republicans. This division allows TNCs are able to prevent any agreement they do not like through immense lobbying.
-Any solutions are also time consuming and costly.
Why are external shocks an issue?
Due to globalisation, the world’s economies are increasingly interdependent. Macroeconomic policies can be used to combat the effects of negative shocks to the economy.
What are some examples of external shocks?
-Covid 19 pandemic – health considerations take priority over economic policy § Sudden increase in oil prices
-Severe weather events (eg Tsunami or drought that affects crops)
-Major financial crisis
-Civil unrest disrupting transport links
-Cyber attacks affecting communications § Wars (Ukraine, Gazza)
What are some examples of the government using macroeconomic policies to control external shocks?
-Tax breaks, low interest rates, fir-low schemes and government subsidies were all used in an attempt to control the impacts of COVID.
-One example could be a commodity price shock, for example where oil prices greatly increase. The government could use expansionary policy to reduce the impact of a fall in GDP or they could use deflationary policy to reduce the impact on inflation.
-Another example may be a financial crisis, where the government can use expansionary policy to increase AD. It is estimated that shocks in the global economy accounted for about 2/3 of weakness in the UK output after the financial crisis, due to the impact on trade.
What factors can cause difficulty in macro-economic policy making?
-Inability to control external shocks
-Inaccurate information / forecasting
-Risks and uncertainties
-Uncertainty how people will respond
-Limited policies available in Eurozone
How can risks and uncertainty cause issues for policy makers?
-The government cannot accurately predict the future and so it is difficult for them to know whether extra spending is necessary etc. They can’t know the full impact of their decisions as consumers often react unexpectedly and this could undermine government policy. Managing risk is an essential part of good decision making.
How can inaccurate information cause policy makers problems?
-Short term information, such as GDP figures for the previous month, are often inaccurate meaning the government is unable to see if there are problems within the economy.
-Trying to cut down on tax evasion and avoidance is difficult as the government does not have the full picture on the level, method and culprits of avoidance.
-The Bank of England makes its decisions based on past data but it is possible trends in the economy may be changing so past data gives an inaccurate picture of where the economy is currently heading.
-Extreme interest rate policies may make it hard for the BoE to make accurate analyses on the economy.
-Full cost-benefit analyses can be time consuming and costly and it is impractical.
How can external shocks cause policy makers problems?
-The government is unable to control and prepare for these external shocks; the best they can hope to do is lessen their impact.
-Since every situation is different, it may be difficult to know the best method to solve the problem.
-Policies employed by policy makers may not have their intended impacts and it may undermine current policies in place, for example Brexit has delayed government plans to balance the budget.
How can the lack of policies in the Eurozone cause problems for policy makers?
-Countries in the Eurozone are constrained by lacking economic policies usually open to countries.
-They were unable to devalue their currency because they were pegged to the value of the Euro
-They were unable to pursue independent monetary policy (e.g. quantitative easing) – because monetary policy is set for whole Eurozone.
-In a recession, countries might like to pursue expansionary fiscal policy. But, the need to reduce budget deficits made this option unavailable.
