2.6. Macroeconomic Objectives and Policies
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What are the four key macroeconomic objectives of the government?
Economic growth
Low unemployment
Low and stable inflation
Balance of payments equilibrium on the current account
What is the typical long-run trend rate of economic growth in the UK?
About 2.5% per year.
Why might emerging and developing economies focus on economic development before economic growth?
To improve living standards, increase life expectancy, and improve literacy rates.
What is the government’s target unemployment rate and why?
Around 3% to account for frictional unemployment and ensure most of the labor force is productively employed.
What is the UK government’s inflation target and how is it measured?
Target is 2% inflation, measured by the Consumer Price Index (CPI).
What happens if UK inflation deviates by more than 1% from the target?
The Governor of the Bank of England must write a letter to the Chancellor of the Exchequer explaining the cause and intended actions.
Why is balance of payments equilibrium on the current account an important macroeconomic objective?
It ensures the country can sustainably finance the current account, supporting long-term economic growth.
Name three additional macroeconomic objectives besides the four key ones.
Balanced government budget
Protection of the environment
Greater income equality
Why is maintaining a balanced government budget important?
It controls state borrowing, prevents escalation of national debt, enables cheap borrowing in the future, and eases repayments.
What does the environmental protection objective aim to achieve?
Long-run environmental stability, sustainable use of resources, and minimization of pollution.
How does the government aim to reduce income inequality?
By minimizing the gap between rich and poor to promote a fairer society.
What policies do governments use to achieve macroeconomic objectives?
Demand-side policies (monetary and fiscal) and supply-side policies.
What is the difference between expansionary and deflationary demand-side policies?
Expansionary policies increase aggregate demand (AD) to promote growth; deflationary policies decrease AD to control inflation.
Define monetary policy.
The use of interest rates or money supply control by the central bank to influence aggregate demand.
Define fiscal policy.
Use of government borrowing, spending, and taxation to manipulate aggregate demand and improve macroeconomic performance.
What is the ‘repo rate’?
The official base interest rate at which the Bank of England lends money to banks for short-term loans.
How does a rise in interest rates reduce aggregate demand? (List the 4 mechanisms)
Higher borrowing costs reduce investment and consumption, especially durables and housing.
Asset prices fall, causing a negative wealth effect and reduced consumption and investment.
Consumer and business confidence drops, lowering spending and investment.
Higher interest rates attract foreign capital, raising the pound’s value, making exports expensive and imports cheaper, reducing net trade.
What negative impact can exchange rate changes have due to interest rate changes?
Exports may fall and imports rise, causing a balance of trade deficit.
Why might changes in interest rates take a long time to affect the economy?
Effects can take up to 2 years to fully materialize, and small changes may not influence decisions.
What is a problem when interest rates are already very low?
They cannot be lowered further to stimulate demand (liquidity trap).
Why might monetary policy fail even if interest rates are low?
Lack of confidence means consumers/businesses won’t borrow or banks won’t lend despite low rates.
How can prolonged high interest rates negatively impact the economy?
They discourage investment, reducing Long-Run Aggregate Supply (LRAS) and long-term growth potential.
What is quantitative easing (QE)?
QE is when the Bank of England buys assets in exchange for money to increase the money supply and stimulate demand during times of very low demand.
What do the terms ‘quantitative’ and ‘easing’ mean in quantitative easing?
Quantitative’ means a set amount of money is created; ‘easing’ refers to reducing pressure on banks.
How does quantitative easing help prevent a liquidity trap?
QE injects money directly into the economy, stimulating demand when low interest rates alone cannot.
How does the Bank of England use reserves to encourage lending?
It increases banks’ reserves (accounts at the Bank of England), encouraging banks to lend more money.
Why did buying reserves not always lead to increased lending after the financial crisis?
Many banks preferred to keep money in reserves rather than lending it out.
What alternative asset purchases does the Bank of England make to stimulate the economy?
The Bank buys securities or bonds from private sector institutions like insurance companies and pension funds.
How does quantitative easing increase consumption and investment?
Asset prices rise, creating a positive wealth effect.
Lower yields on assets reduce borrowing costs.
Increased money supply means more spending and lending by banks.
Lower interest rates encourage borrowing and spending.
What is the ‘positive wealth effect’ caused by quantitative easing?
When asset prices (shares, houses) rise, people feel wealthier and spend more.
How does QE affect interest rates?
Increased money supply lowers the price of money (interest rates), encouraging borrowing and spending.
List some risks/problems associated with quantitative easing.
Risk of high inflation or hyperinflation if uncontrolled.
May only increase demand for second-hand goods, not new production.
No guaranteed rise in consumption if confidence is low.
Can inflate housing prices, worsening geographic mobility issues.
Raises share prices, increasing wealth inequality.
Can create dependency in banks and economies, especially in the Eurozone.
What is the main role of the Bank of England in monetary policy?
To control monetary policy, including setting base interest rates and managing quantitative easing.
Who makes the key decisions about monetary policy in the UK?
The Monetary Policy Committee (MPC) of the Bank of England.
What is the inflation target of the Bank of England?
2% inflation measured by the Consumer Price Index (CPI).
What happens if inflation falls below 1% or rises above 3%?
The Governor of the Bank of England must write a letter to the Chancellor explaining why and what will be done.
What has been the general trend in the Bank of England base rate since 2009?
Kept at a low 0.5%, reduced further to 0.25% after Brexit, then gradually increased due to inflation pressures.
Why was the base rate reduced to 0.25% after the Brexit vote?
o stimulate the economy following uncertainty caused by Brexit
What conditions does the MPC look for before raising interest rates?
They wait until the negative output gap is eliminated and the economy is growing strongly.
How many members are in the Monetary Policy Committee and what is their composition?
Nine members — five from the Bank of England (including the Governor) and four independent external experts (mainly economists).
How can the government influence aggregate demand (AD) using fiscal policy?
By changing taxation (income tax, corporation tax) which affects consumption and investment, or by changing government spending which directly affects AD.
What happens to AD if income tax rises?
Disposable income falls, reducing consumption and thus decreasing AD.
What is the effect of a rise in corporation tax on AD?
It reduces firms' post-tax profits, leading to less investment and a decrease in AD.
What is the effect of increased government spending on AD?
It directly increases AD since government spending is a component of AD.
Define a government budget deficit and surplus.
Deficit: Government spends more than it receives.
Surplus: Government receives more than it spends.
What is the difference between direct and indirect taxes?
Direct taxes are paid directly by individuals to the government (e.g., income tax).
Indirect taxes are passed on by the person charged to another party, usually the consumer (e.g., VAT).
What are the four highest revenue-raising taxes in the UK?
Income tax, national insurance, VAT, and corporation tax.
What are the current UK income tax bands?
Personal allowance: £11,850 tax-free (2018).
Basic rate: 20%
Higher rate: 40%
Additional rate: 45% (on income above £150,000).
What is the standard rate of VAT and which goods are exempt or lower rated?
Standard VAT is 20%. Food and children's clothes are exempt; domestic fuel/power are charged at 5%.
How can fiscal policy impact long-run aggregate supply (LRAS)?
Cuts in government spending on education or technology may reduce LRAS by harming productivity.
How can taxes and government spending affect income inequality?
Some fiscal policies aimed at demand management may increase income inequality or reduce incentives.
What political issues can limit the use of fiscal policy?
Governments may avoid raising taxes to reduce demand because it can be unpopular and risk losing elections.
Why is expansionary fiscal policy difficult during austerity?
Because the government needs to control its budget and reduce deficits, limiting its ability to increase spending.
What role does the multiplier effect play in fiscal policy?
The larger the multiplier, the bigger the impact of government spending or tax changes on AD.
How do classical economists view the multiplier effect?
They argue it is nearly zero and that demand management has little long-run effect on output.
How do Keynesian economists view the multiplier effect?
They believe it can be large if fiscal policy is targeted correctly, especially when there is spare capacity.
What determines the effect of a change in AD on output and prices according to Keynesian LRAS?
It depends on where the economy is operating:
At full employment, AD increase mainly causes inflation.
With high unemployment, AD increase leads to higher output.
What are the main drawbacks of demand-side policies?
Time lags in policy effects.
Expansionary policies tend to cause inflation; deflationary policies tend to cause unemployment.
They cannot achieve low inflation and low unemployment simultaneously in most cases.
How does monetary policy differ from fiscal policy in influencing AD?
Monetary policy can increase demand without increasing government spending or deficits.
Why do classical economists prefer monetary policy over fiscal policy?
Because it does not require government spending increases and is less likely to cause budget deficits.
How can fiscal policy impact the supply side of the economy?
By investing in education and infrastructure, it can increase LRAS and improve long-term growth.
How can fiscal policy reduce inequality?
By targeting specific groups, e.g., increasing benefits, it can raise AD for lower-income groups and reduce income inequality.
Why is it important to use demand-side policies alongside supply-side policies?
To achieve all macroeconomic goals: stable inflation, economic growth, low unemployment, and sustainable development.
What was the unemployment rate during the Great Depression in the UK and the US?
Over 15% in the UK and almost 25% in the US.
Which industries were most affected by the Great Depression in the UK?
Primary industry and manufacturing, especially those reliant on exports.
What event is considered the trigger for the Great Depression?
The Wall Street Crash of 1929, a sharp fall in share prices on the New York Stock Exchange.
How did loss of consumer and business confidence contribute to the Great Depression?
Shareholders lost money, firms cut back investment, leading to a downward spiral in aggregate demand (AD).
What role did the US banking system play in causing the Great Depression?
Banks lent too much during the 1920s; after the crash, many failed, reducing loans and confidence, causing AD to fall.
How did protectionism contribute to the Great Depression?
Reduced world trade, decreased AD, and worsened bank failures due to decreased exports, exemplified by the Smoot-Hawley Tariff Act (1930).
Why was the UK’s commitment to the gold standard a problem during the Great Depression?
The pound was overvalued due to rejoining the gold standard in 1925, making exports expensive and worsening the depression.
What was the UK government's initial fiscal policy response to the Great Depression?
Emergency budget cuts including a 10% cut in public sector wages/unemployment benefits and an increase in income tax from 22.5% to 25%, which reduced AD.
Why did the UK defend the pound with high interest rates during the Great Depression?
To maintain the gold standard and prevent the pound from falling, but high rates also decreased AD.
When and why did the UK leave the gold standard during the Great Depression?
On 21 September 1931, due to speculative attacks on the pound and economic pressures.
What was the economic impact of the UK leaving the gold standard?
The pound fell by 25%, and the Bank of England cut interest rates by 2.5%, boosting AD through higher exports and consumption.
How did recovery differ regionally in the UK after the Great Depression?
London and South East recovered sooner; Wales, North, and Scotland did not reach full employment until 1941.
What was the US government’s initial response to the Great Depression?
Similar to the UK, focusing on balanced budgets before Roosevelt’s New Deal.
What was Roosevelt’s New Deal?
A Keynesian expansionary fiscal policy with public sector investment, work schemes, and fiscal stimulus to fight unemployment.
When did the US reach full employment following the Great Depression?
In 1943, two years after entering WWII.
How did the 2008 Global Financial Crisis begin?
Problems in US mortgage lending, especially sub-prime mortgages leading to repossessions and negative equity.
What was “moral hazard” in the context of the 2008 GFC?
Banks and workers pushed risky mortgages due to bonuses, ignoring the risk of non-repayment.
How did securitization contribute to the spread of the GFC?
Banks packaged ‘prime’ and ‘sub-prime’ mortgages together and sold them, spreading risk but increasing systemic exposure to bad debts.
What triggered the collapse of confidence in banks during the GFC?
The revelation that many banks held risky assets and the failure of Lehman Brothers in 2008.
What happened to Northern Rock in the UK during the GFC?
It faced a run on deposits and was nationalized due to bad loans and liquidity problems.
What fiscal and monetary policies did the UK and US governments implement during the GFC?
Nationalization of banks, guarantees for savers, record low interest rates, and quantitative easing (QE).
How did US fiscal policy during the GFC differ from the UK’s approach?
: The US pursued more aggressive fiscal stimulus under Obama, while the UK prioritized reducing the national debt from 2010.
Which crisis was more severe: the Great Depression or the Global Financial Crisis?
The Great Depression was much more severe in terms of unemployment and economic impact.
What are supply-side policies?
Government policies aimed at increasing the productive potential of the economy and shifting the supply curve to the right.
How do supply-side improvements occur naturally over time?
They often happen independently of government through private sector actions like investment.
How can the government influence supply-side improvements?
By using supply-side policies to increase and speed up improvements in the economy.
Can supply-side policies target specific sectors of the economy?
Yes, they may be applied across the whole economy or targeted at specific markets for growth in that sector.
What are market-based supply-side policies?
Policies designed to remove barriers that prevent the free market from working efficiently, reducing output and causing higher prices.
Give examples of barriers that market-based policies aim to remove.
Barriers that reduce workers’ willingness to take jobs, cause inefficient production, high prices, or discourage risk-taking.
What are interventionist supply-side policies?
Policies designed to correct market failure, such as government provision of underprovided goods like education.
Why might governments intervene in investment decisions of firms?
Because firms may focus on short-term profits for shareholders instead of long-term investment, so government encourages investment.
What is the view of free market economists on supply-side policies?
They generally support market-based policies and prefer a smaller government role in the economy.
What do economists who support interventionist policies argue?
That the free market is not always efficient and government intervention is necessary to improve it.
How do supply-side policies affect the aggregate supply curve?
They shift the aggregate supply curve to the right, indicating increased productive capacity.
How do supply-side policies increase the size of the workforce?
By increasing incentives for people to work or for firms to employ more people, resulting in more goods and services produced.
How does reducing benefits or taxes increase incentives for work?
It raises the opportunity cost of being out of work, making work financially more attractive than receiving benefits.
What is Universal Credit, and how does it help increase workforce participation?
Universal Credit helps ease the transition into and out of work, reducing the financial disincentive to work.