2.6 macroeconomics objectives and policies

fiscal policy

the manipulation of government spending, taxation, and government borrowing to influence the level of economic activity. it is a demand-side policy

expansionary fiscal policy

increases in government spending and cuts to tax rates in order to increase AD and achieve macroeconomic objectives

contractionary fiscal policy

decreases in gov spending and rises to tax rates in order to decrease AD and achieve macroeconomic objectives

the government budget

a plan of expected government revenues (mostly through taxes) and proposed government spending for the coming financial year. The budget outlines a government’s fiscal policy for the year ahead

fiscal policy aims

* stimulate growth and employment during times of recession
* maintain a stable economic cycle that minimises ‘boom and bust’
* keep inflation on target-2%

expansionary FP transmission mechanisms

* increase government spending
* increases g
* cut in income taxes
* higher disposable income, increased c


* cut in corporation taxes
* higher profits for firms, increased I

impacts of expansionary FP

* increased output
* inflation
* decreased U/E ( decreased -ve output gap)
* worsening CA deficit (X-prices increase)

what does the magnitude of impacts of FP depend on?

the initial macroeconomic equilibrium

contractionary fiscal policy transmission mechanisms

* reduced gov spending
* rise in income taxes
* rise in corporation taxes

impacts of contractionary FP

* decreased output
* disinflation
* increased U/E ( increased -ve output gap)
* improved CA deficit ( x-prices decrease)

balanced budget

when government expenditure is equal to gov revenue

budget deficit

government spending exceeds gov revenue

* net injection into CFI
* likely to occur under expansionary FP

budget surplus

when government revenue exceeds the gov expenditure

* net withdrawal to CFI
* likely to occur under contractionary FP

types of budget deficit

cyclical: takes into account fluctuations in G and T due to the economic cycle. eg in a recession, T falls but spending on unemployment benefits increases.

* should balance out with cyclical surpluses in the economic cycle
* occurs due to automatic stabilizers

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structural: a deficit occurs even when the economy is at full employment.
* national debt will be growing

government aim

* a balanced budget over the economic cycle
* they would allow a budget deficit in a recession, borrowing money to achieve high levels of G and allow low levels of T to stimulate AD growth and economic recovery
* they would aim to run a budget surplus in a boom in order to pay back the borrowing made in downturns when the economy is at its healthiest.

how does the government borrow money?

government bonds: A debt security issued by gov. to public individuals and institutions.

* bonds can pay interest payments called coupon payments. they are considered low-risk investments since they are backed by issuing government

national debt

the accumulation of all previous public sector borrowings that have not yet been paid, plus interest

key issue of debt/ persistent budget deficits

not only will the borrowed amounts have to be repaid at some point, but the debt will have to be serviced

* interest has to be paid
* this can compound and start to spiral if the government is not careful, potentially impacting on the credit rating of the country and its ability to borrow and support itself in the future
* generally, the level of debt is problematic if it is rising faster than GDP

evaluating fiscal policy

* magnitude: the size of the change in G/T will vary the impacts
* multiplier: influence the size of changes in AD
* marginal propensity to consume: extent AD rises depends on the MPC of those who receive the tax break. more effective on the poor
* spare capacity: impact of expansionary FP differs based on proximity to Yfe (large output gap= high growth, low inflation and vice versa)
* time lag: the full effect takes time to impact the economy
* short run vs long run: Keynesian economists support strong FP responses as U/E can persist without action. however, it has little effect on productive potential, so is a limited source of LR growth

monetary policy

the manipulation of the rate of interest, money supply and exchange rates to influence the levels of economic activity. demand- side policy

deflationary (tight) monetary policy

increases interest rates/ cuts to the money supply to decreased AD and reduce inflation

reflationary (loose) monetary policy

decreases in IR / increases to money supply in order to increase AD and increase inflation

the bank of england (BOE)

the central bank in the UK, responsible for controlling monetary policy to meet objectives

monetary policy committee (mpc)

a committee led by the governor of the BoE , who meet monthly to assess the state of the economy and decide whether to alter interest rates

* independant of government to ensure no policy myopia

monetary policy aim

achieve stable inflation but also target growth and increase employment

interest rates

a percentage charged on the total amount you borrow or save

* for borrowers: the amount you are charged for borrowing money-percentage of total loan
* for savers: amount received for lending money

the ‘base rate’

the interest rate at which the BoE lends to financial institutions. set by the MPC after assessing the state of the economy

commercial rates

the rates at which businesses and households borrow/save with financial institutions. determined by the base rate as well as other factors. when the base rate increases the commercial rates are expected to increase

the monetary policy transmission mechansim

describes how changes made by the central bank to the base rate flow through to economic activity and inflation

deflationary MP transmission mechanisms

* increased base rate leads to increased commercial rates


* consumption decreases
* higher reward for saving/cost of borrowing
* investment decreases
* fewer investments will provide higher terun than saving profits
* negative wealth effects further cut consumption
* assets fall in price due to lower demand
* decreased net exports
* exchange rates rise as the return of holding assets in domestic currency is increased relative to to others ( inflow of ‘hot money’

impacts of deflationary mon.pol

decreased output, disinflation, increased U/E ( increased -ve output gap), worse CA balance

what does the impact of mon.pol depend on

initial macroeconomic equilibrium

reflationary MP transmission mechanisms

* decreased base rate leads to decreased commercial rates
* consumption increases
* investment increases
* wealth effect boosts C further
* increased net exports (outflow of hot money)

inflationary MP impacts

increased output, inflation, decreased U/E ( decreased -ve output gap), improved CA balance

quantitative easing

the injection of money into the economy, via the purchase of assets by the bank of England, to encourage spending and hence alter inflation

* often the assets bought are second hand gov bonds held by financial institutions

why might central banks use quantitative easing?

QE is used when inflation is below target and the economy is at risk of a liquidity trap​

* **Liquidity Trap:** A situation where savings rates remain very high despite low interest rates which have little scope to be lowered further (interest rates cannot be cut below 0% - The Zero Lower Bound)​
* This is because if commercial rates were below zero, banks would be charging people to save and paying them to borrow.​
* Savers could get a better return (0%) from simply storing their money in a safe; Borrowers would be incentivised to borrow as much as possible as their debt will erode itself​

how can the effectiveness of QE be offset?

* contractionary fiscal policy
* whilst QE is reflationary, so increases AD, governments may want to stabilize their budget balances so cut down on their spending and raise taxes at the same time as QE is taking place

quantitative easing workings

* Quantitative easing works by increasing the money supply​


* The BoE buys assets from financial institutions using electronically created money. ​
* Commercial banks now hold extra cash. This should boost lending to consumers and firms, and both C and I should increase. Therefore QE should boost AD and increase price level​
* Furthermore, increased demand for government bonds from the BoE increases the market price, which pushes down bond yields (a bond’s rate of return – coupon rate/bond price)​
* This further boosts I, as more investments opportunities will offer hndsigher returns than simply holding bo

quantitative easing evaluation

* No Guarantee of increased lending​
* Many financial institutions used QE funding simply to improve their own financial stability, increase their liquid assets rather than increasing lending to businesses/consumers.​
* If the economy is suffering, banks may fear a ‘bank run’  where creditors withdraw large sums of cash which the bank may not currently be holding as it has loaned so much out in the past.​


* Furthermore, a lack of consumer/business confidence meant there was a lack of demand for loans​
* The liquidity trap may still persist!​

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evaluating monetary policy

* Magnitude: the size of the change in base rates will vary the impacts
* multiplier: the size of the multiplier will influence the size of changes in AD (stronger multiplier means a smaller policy change is required to have the same effect)
* stage in the economic cycle: business and consumer confidence is important to successful MP
* time lag: takes time to have impact on economy
* conflicts with other objectives:primary target to control inflation can go against growth and U/E targets
* cost-push inflation: monetary policy, and fiscal policy have little power against cost-push infl.

the great depression

a severe worldwide economic depression starting in the USA in 1929 and lasting most of the 30s

great depression causes

* In 1929, after a decade of rapid growth and a huge rise in share prices, the US stock exchange crashed.​
* Widespread share ownership among middle-income households meant consumption plummeted and a huge loss of confidence, slashing investment and causing business closures​
* credit crunch:Banks had to cut lending as loans were not being repaid and nervous individuals withdrew their savings​
* Many had borrowed lots to buy stocks which had now crashed ​​


* The falling demand in the US set off a downward spiral in international demand. ​
* Many economists believe that the simultaneous tightening of monetary and fiscal policy in the late 1920s and early 1930s, combined with the increase in protectionism, turned a tough financial crisis into a deep depression​

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great depression US policy responses initial

**Bad at the Start:** Worsening the depression!​

* **Tariffs:** In 1930, US president Herbert Hoover attempted to protect US industries by increasing tariffs on foreign goods​

**However:** This led to a trade war and world trade contracted, setting off a cycle of ever-falling production. ​

This made the depression more severe but is not considered to be one of the main factors​

* **Austerity:** Initially the US, in line classical economic thought, pursued balanced budgets​

They thought an unbalanced budget would slow business recovery, as a fiscal deficit would lead either to rising taxes (in which case consumers would have less to spend) or government borrowing (which would lead to the private sector crowding out) ​

**However:** Pursuing austerity initial actually acted to prolong the depression!​

Cuts to G further suppress already low AD, stifling actual economic growth​

* **Tight monetary Policy:** Interest rates were raised in September 1931 to preserve the value of the dollar (linked to the Gold Standard) ​

This further restricted credit for businesses, cutting Investment and reducing aggregate demand​Money supply also fell as banking panics caused people to hold more cash in relation to their bank deposits​

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US great depression policy responses improved

In 1933, under the new President Franklin D. Roosevelt, the US utilised the ideas of Keynesian Economics, ​

* **The New Deal:** A series of programs, public work projects, financial reforms, and regulations enacted between 1933 and 1939. ​

Roosevelt raised government spending to 10.7 per cent of output in 1934, funding massive infrastructure projects such as the Lincoln Tunnel and the Hoover Dam​

* **Abandoning The Gold Standard:** By removing the requirement to maintain the value of currency relative to a fixed amount of gold in 1937, the money supply could finally be increased by the Federal Reserve​

Commercial banks could then give out more loans, increasing Consumption and Investment​

however there is debate to whether the huge spending associated with WW2 provided the real boost

the depression in the UK

The UK was relatively insulated as it had experienced no real credit boom in the 1920s​

But as the UK economy relied heavily on trade, the decline in global demand, hit the economy, and with lower exports, the UK went into recession​

UK great depression policy responses

* **Austerity:** The UK, like the US, pursued balanced budgets in line with classical economics​

The Tory government issued an emergency budget in 1931, with huge cuts in public spending and wages​

**However:** Again, pursuing austerity initially actually acted to prolong the depression​

* **Abandoning The Gold Standard:** The UK too removed the requirement to maintain the value of currency relative to a fixed amount of gold, allowing for growth of the money supply​

However, in the UK this took place in 1931, much earlier than in the USA​

The government pursued expansionary monetary policy, cutting interest rates (5.5% to 2%) and escaping deflation in 1934 after prolonged falling prices​

The increased money supply and lower interest rates boosted private sector investment and consumption

depreciation of the pound boosted exports and AD

the global financial crisis

 severe worldwide financial crisis in 2007-08, which sparked the most severe global recession since the Great Depression​

how did the GFC lead to the great recession?

* in trying to increase their profits, banks had loaned out too much to individuals with limited ability to pay them back – ‘sub-prime’ – and had bundled these loans into derivatives such as mortgage-backed securities (MBS) to sell as seemingly low-risk assets​

As the housing market became saturated, interest rates on mortgages rose, making mortgage payments more expensive to pay back, which many couldn’t afford​

When mortgage defaults started to rise in the US, banks started having to write off bad loans, which also slashed the value of MBS​

* **Credit Crunch:** Banks around the world lost money, and nervous depositors withdrew their savings, slashing their ability to loan​

many businesses now struggled to finance or take out loans

US policy responses GFC

* **American Recovery and Reinvestment Act:** Barack Obama in 2009 signed a stimulus plan worth $787 billion, almost 6 per cent of that year’s GDP​
* **Expansionary Monetary Policy:** the Federal Reserve cut the interest rate in stages from 5.25 per cent in 2007 to 0.25 per cent in 2008​

But once this record low had been hit there was no more scope for interest rate cuts!​

* **Quantitative Easing (QE):** The USA used QE to try to revive consumer spending and economic growth​

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UK policy responses GFC

* **initial Fiscal Stimulus:** In the UK, a number of fiscal measures were introduced, amounting to 2.2 per cent of 2009 GDP​


* **Subsequent Austerity:** By 2010 the UK had moved towards measures aimed at reducing the budget deficit, in contrast to the US where this was not a priority. ​**However:** Pursuing austerity initial actually acted to prolong the recession!​Cuts to G further suppress already low AD, stifling actual economic growth​


* **Expansionary Monetary Policy:** The BoE cut the base interest rate in stages from 5.75 per cent in 2007 to eventually 0.5 per cent in March 2009​


* **Quantitative Easing (QE):** The UK also used QE to try to spark economic growth​

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supply side policies

policies that seek to improve the long run productive potential of the economy

market-based supply side policies

increased productive potential from allowing markets to operate more freely ( less gov interference), boosting competitiveness and efficiency

interventionist supply side policies

gov intervention in markets designed to promote factors of production where the free market would fail to do so

importance of supply-side policies for the economy

* **Long term growth:** Increases in AD with stationary AS will eventually see no growth in actual output​
* **Higher living standards:** Policies that increase productivity will lead to a greater output derived from factors of production, and more goods and services to go round​


* **Non-inflationary growth:** Allows output to rise into the long run without increased price level​


* **Welfare gains:** More competition can lower prices, boosting consumer surplus​


* **International competitiveness:** Firms can compete with foreign rivals, boosting net exports​


* **Budget Balance:** Increased profits and incomes will boost tax revenues for government ​

Supply-side policies evaluations

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* **Knock on effects:** Supply-side policies which involve increased government spending (e.g. education reforms) may also increase AD​
* **Recessions:** supply-side policies cannot tackle an output gap caused by suppressed AD​
* **Unemployment:** Short term unemployment may occur as capital replaces workers​
* **Time lag:** Policies may take time to have an effect on AS​
* **Likelihood of government failure:** There are a number of cases of poorly administered government supply-side polices which have not had the desired outcome​

examples of market based supply-side policies+ evaluation

* **Privatization:** The transfer of inefficient state-owned firms into the private sector​Firms are exposed to competition and face a profit motive, promoting productivity gains ​

**Evaluation 1:** Limited gains still to be made as most UK government owned firms have already been sold off​

**Evaluation 2:** Privatisation may just see a state-owned monopoly become a privately owned monopoly – prices increase, quality decreases​

* **Deregulation:** Removing legal restrictions on business to encourage competition​
* Increased competition for customers, means increased productivity in order to lower prices​

**Evaluation:** Possible disadvantages of excessive choice and deteriorating quality​

* **Reducing corporation tax:** Cutting taxes on business profits​

Firms will have more retained profit to invest, thus increasing the quantity of FoP or their productivity through increased R&D (research and development)​

**Evaluation:** Money may not be spent on investment. R&D tax credits instead?​

* **Labour market reforms:** Reducing the power of trade unions and other regulations​

Boosts labour productivity, as staff are spending more time at work and less time on strike​

Unions can’t longer make unreasonable wage demands, firms can cut costs boosting SRAS​

**Evaluation:** any further weakening of trade unions may de-motivate workers​

examples of interventionist supply side policies + evalutation

* **Education and training:** Increased quantity and quality of education and training​Labour becomes more productive, productive potential will rise​

**Evaluation:** Time lag while people train​

* **Work visas/immigration:** Improvements in the ease of immigration into an economy ​

Increasing the quantity of Labour is an increase in FoP, and thus increases potential output​

**Evaluation:** If other FoP are not sufficient there could just be increases in unemployment​

* **Public Sector Investment:** Government spending on improved infrastructure such as transport links can boost productivity​

Lower costs of transportation and reduced time spent commuting ​

**Evaluation:** In a crowded country like the UK, it can be difficult to increase transport capacity​

* **Increased Housing Supply:** Building affordable homes in expensive areas can make it easier for workers to move and find jobs reducing geographical immobility​

evaluations: Firms can suffer from labour shortages in areas that have become very expensive to live in​

* **Healthcare provision: Health care spending which improves a nation’s health can improve labour productivity​**

evaluation: Firms can face substantial costs from time lost to ill-health​

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growth vs inflation conflict

If there is rapid economic growth, it is more likely that inflationary pressures will increase.

Inflation is particularly likely to occur when growth is above the long run trend rate, and AD increases faster than AS.

(This leads into a similar conflict between unemployment and inflation

growth vs inflation causes

• Competition for resources: If the economy is growing very quickly, firms have difficulty employing sufficient quantities scarce resources such as skilled labour.

  This can lead to wage inflation, which cause higher prices.

• Rationing function of price mechanism: If demand grows faster than supply, firms will respond to shortages by putting up prices.

  If this happens for the majority of goods, the price level will rise.

• Demand side Policies: Policies chasing short run actual economic growth can contribute to this conflict.

  Expansionary fiscal, but also reflationary monetary policy of late

the lawson boom

• in the late 1980s the UK experienced a high rate of economic growth (4-5% a year).

• This growth rate was above the long run trend rate of growth, fuelled by rocketing demand, causing inflationary pressures to increase.

• Also, as the growth was so quick for a developed economy, there were supply constraints which pushed up commodity prices. 

• This economic boom of the 1980s proved unsustainable and caused very high inflation (9.5% in 1990).

• Ultimately, the boom led to the recession in 1991, as the government drastically increased interest rates to try and control inflation.

inflation vs growth eval

: Supply led growth

If growth is sustainable – if it is close to the long run trend rate, then LRAS will increase at the same rate as AD, and therefore, we will not see inflation.

The Great Moderation: Between 1993 and 2007 the UK had a long period of economic expansion but with no spikes to inflation.

This (wrongly) led some economists to claim an end to boom and bust of economic cycles.

growth vs ca balance conflict

When economic growth is led by consumer spending, it tends to cause a deficit in the current account. Also, high economic growth may increase inflation and make exports less competitive

growth vs ca balance causes

Causes:

Increased consumer spending: When consumers spend more money, there will be an increase in expenditure on domestic goods (C), boosting AD as well as more spending on imports, worsening the current account balance.

Especially true in the UK, where traditionally we have a high marginal propensity to import (MPM).

Competitiveness: High economic growth can raise prices, so exports will be less competitive.

If this happens for the majority of goods, the price level will rise.

UK Example: The late 1980s saw an economic boom and a growing current account deficit. The recession of 1992, saw a fall in import spending and a decline in the current account deficit.

growth vs ca balance eval

: Export led-growth.

If economic growth is export-led, then there can be an increase in economic growth without causing a current account deficit.

E.g.Germany has seen strong economic growth, but it often runs a current account

growth vs environmental degradation

With increased output and consumption we are likely to see costs imposed on the environment

growth vs environmental degradation causes

• Negative externalities in production: Noise pollution and lower air quality arising from industrial pollution and road congestion.

• Increased electrification: Growth in living standards is based on the increased use of G&S using electricity, likely requiring increased use of polluting fossil fuels.

• Trade: Increases in international trade and travel will increase pollution and CO2 emissions.

• Waste: Increased production and consumption of short life products will lead to more waste.

growth vs environmental degradation costs

• Unsustainable: Over-use of natural resources e.g. deforestation or over-exploitation of fish stocks can cause the collapse of ecosystems.

• Tragedy of the commons: Individuals with free access to a resource will act in their own self-interest and, contrary to the common good, may cause depletion of the resource leaving less available for future use.

• Climate Change: Global warming leads to rising sea levels, volatile weather patterns and could cause significant economic costs.

  Soil erosion: Deforestation in pursuit of economic growth, damages soil and makes areas prone to drought.

growth vs income inequality

With increased output, there will be increased incomes. If these gains are not evenly distributed, inequality will widen.

growth vs income inequality causes

• Very high increases in the pay of people in the top-paying jobs: The highest rewards go to households with the most valuable skills, education and access to capital.

  High pay for shareholders (FoP - Enterprise, Factor Income - profit), despite not doing the actual work.

• Increased wealth inequality including rising property prices: Fast-growing economies often seen a rapid increase in property prices.

  Owners gain whilst renters suffer, also buy to let investors gain.

• Urbanisation: Growing gaps between urban and rural areas, rural poverty sets in.

growth vs income inequality costs

• Health and Education: Two tiered systems lead to unrealised potential and lower growth.

• Limited Investment: The poorest in society and unable to access finance to realise investment opportunities, constraining enterprise and growth.

• Social tensions: Lower living standards & less political stability.

  Can limit inward FDI  into the future.

• Long term growth: Rich have lower APC, so inequality lowers the rate of consumption

growth vs balanced budget

A government may look to reduce a fiscal deficit in order to achieve a balanced budget (austerity), but this might act to reduce the growth of output.

growth vs balanced budget causes

Higher taxes: These will act to constrain consumption and investment, constraining aggregate demand.

Lower government spending: A direct reduction in the demand for goods and services will constrain actual output.

growth vs balanced budget costs

Generational inequality: Why should one generation have to suffer higher taxes/lower public spending in order to pay back borrowing made for the benefit of previous generations?

growth vs balanced budget eval

Automatic Stabilisers

This conflict only exists for discretionary fiscal policy.

When an economy grows in a boom, automatic stabilisers act to reduce the fiscal deficit.

Higher tax revenues are received from growing incomes/profits.

Less spending on benefits and fiscal stimulus is required.

unemployment vs inflation

When we have period of high unemployment we often see low inflation, and vice versa (at least in the short run)

unemployment vs inflation causes

Labour shortages: With economic growth firms want to hire workers and there is less unemployment.

However, shortages in labour may occur, pushing up wages, meaning higher costs of production and higher disposable incomes, leading to inflation

Low demand: When AD is low, there will be less demand pull inflation and so prices won’t rise quickly

However, labour is derived demand for output. A low AD can lead top a negative output gap implying growing unemployment

phillips curve

A curve showing the stable and inverse relationship between inflation and unemployment

Phillips’ original data points shown here are from 1861-1913, and a line of best fit has been added

phillips curve evaluations

Stagflation: An economy experiencing high inflation and high unemployment simultaneously.

1970s UK: Phillips’ relationship between unemployment and inflation began to break down in the UK as high unemployment and high inflation began to occur together due to oil price shocks harming SRAS

Supply-side impacts: The Phillips Curve model does not recognise the impact that changes in the supply-side of the economy might have

Result: As a consequence, it has become accepted that the original Phillips Curve is an effective model in the short-run, but a new long-run model was required

long-run phillips curve

In the long run, there is no trade off between unemployment and inflation (according to classical economics).

We expect output to return to Y_FE In the long run, where there is ‘full employment’ meaning that our labour market has cleared and only voluntary unemployment remains.

This level of unemployment is referred to as the ‘Natural Rate of Unemployment’ (NRU).

The long run Phillip’s Curve is therefore a vertical line at this level of unemployment. (approximately 6% in the data set).