2.6 Macroeconomic objectives and policies

Main macroeconomic objectives

High economic growth: strong, sustained, sustainable. 2.5% in the UK.

Low unemployment: full employment. Unemployment rate at 3%.

Low and stable rate of inflation: 2% target

Balance of payments equilibrium: on current account

Other macroeconomic objectives

balanced government budget

Protection of the environment

Greater income equality: fair + balanced

2 types of demand side policies

Fiscal

Increase government spending and decrease taxation in order to increase AD.

Monetary

Decrease interest rate,changes to money supply and exchange rate(by the central bank) in order to increase AD.

Reasons for the need of expansionary fiscal policies(↑ AD) on macro objectives - link to multiplier effect

Boost growth

Reduce unemployment

Increase inflation

Redistribute income

Reasons for the need of contractionary fiscal policies (↓ AD)

Reduce inflation

Reduce budget deficit(less borrowing from bank)/ national debt

Redistribute income

Reduce current account deficit

Expansionary fiscal policy examples

↓ Income tax: chain of reasoning from 2.2AD

↓ Corporation tax: cut regressive taxes e.g. VAT → ↑ income for poor more than rich who have higher MPC.

↑ Government spending: on healthcare, education

Automatic stabilisers

Fiscal policy tools that influence GDP + counter fluctuations in the economic cycle.

1. Progressive income tax

IN A BOOM: ↑ incomes, workers pay higher tax, ↑ tax rate, C ↓, growth ↓.

2. Welfare benefits

IN A BOOM: unemployment benefits ↓, gov. spending ↓, growth ↓.

Problems with expansionary fiscal policies

Demand pull inflation: exceeds target.

Current account deficit: economic growth→higher income→more spending on imports.

Worsening of government finances: budget deficit rises, policies needed to be funded which come out of government budget. May need taxes to rise to fund it.

Time lags: AD won’t increase straight away. Policies take time to implement e.g. infrastructure being built may take years.

Crowding out effect: increased gov. spending on public sector drives down private sector spending- too much reliance on gov. spending.

Evaluation of expansionary fiscal policies

Size of output gap: if AD is closer to full employment, demand pull inflation will increase more than real GDP. (use graph to show)

Size of multiplier: the bigger the multiplier, the bigger the increase in AD. A bigger multiplier means less of a need for policies.

State of gov. budget: If there is budget deficit/ large national debt, gov. can’t finance policies.

Self-correcting in recession: classical view- economy will correct itself, eventually wages will fall, economy will return to full employment on its own.

Reasons for expansionary monetary policy(↑ AD)

Increase inflation

Increase growth

Reduce unemployment

Reasons for contractionary monetary policy(↓ AD)

Reduces inflation

Prevent excessive borrowing + growth in house price

Reduce current account deficit

Expansionary monetary policy examples:

↓ credit card interest rates(consumer borrowing): MPS ↓, ↑ consumption

↓ mortgage rates: ↑ consumption

↓ rates on business loans: ↑ investment

weaker exchange rate: low interest rates, less incentive to save, savings move out of country(hot money outflows), increasing supply of currency which depreciates it, ↑ net exports

Cons of monetary policy

Tradeoff of macroeconomic objectives: demand pull inflation+current account deficit as a result of economic growth.

Negative impact on savers: Rate of return on savings decreases + if inflation rate is higher than nominal interest rate, real return on savings may be negative.

Time lag: takes time for interest rate to be cut + boost AD.

Evaluation for effectiveness of monetary policy

Size of output gap: If close to full employment, there will be a smaller ↑ in output and larger demand pull inflation.

Consumer+business confidence: lower confidence means less likely to borrow + consume/ invest even if interest rate falls.

Banks willingness to lend: cutting interest rate is pointless in banks aren’t willing to lend

Size of interest rate cut

Supply side policies

Policies designed to increase the productive capacity of the economy, shifting LRAS to the right.

Interventionist policies: Government intervenes to boost LRAS in the economy.

Market based: Increasing competition + free market efficiency.

Reasons for supply side policies(↑ AS)

Reduced inflation

Boosts growth

Reduces unemployment

Reduced current account deficit

Interventionist policies

Gov. spending on education/ training: improve quality of labour

Gov. spending on infrastructure: can reduce cost of production(transport), improve productivity(healthcare)

Subsidies to firms to promote investment: investing in R&D-improves productivity(↓ LRAC), increases quality of capital

Market-based policies

Tax reform

Lower income tax: incentivises inactive population to enter labour force + active population to work harder to earn more disposable income→quantity of labour increases

Lower corporation tax: more retained profits→use for investment→quality of capital increases

Labour market reform

Reduce benefits: increased incentive to work→quantity of labour ↑

Reduce minimum wages: reduces cost of production→boost productive efficiency

Competition policy: boost competition→LRAC of production decreases→productive efficiency ↑.

Privatisation

Deregulation

Trade liberalisation

Cons/ evaluation of supply side policies

No guarantee of success: opportunity cost

Time lag + cost: Policies like infrastructure may take years to finish + increase LRAS, policies are costly

Size of output gap: if economy is in recession, supply side policies are useless in boosting growth

2 types of budget deficit.

Structural: budget deficit at full employment- not earning enough tax revenue to fully cover gov. spending.

Cyclical: budget deficit in a recession- gov. spending on benefits rises.

Pros + cons of budget deficit

PROS

Higher growth, lower unemployment: increase AD.

More spending on education, infrastructure, healthcare: boost living standards

Reduction in income inequality: less regressive taxes, benefits for low income workers.

CONS

Deterioration of gov. finances: ↑ gov. spending leads to more national debt- lower credit rating, impact future pop. as debt must be paid back-opportunity cost as spending can go towards something else.

Macroeconomic objectives conflict: Inflation increases + current account deficit worsens- rise in incomes means more spending on imports + higher demand pull inflation as AD rises

Evaluation of budget deficit

State of gov. finances: if gov. has a lot of national debt, budget deficit will worsen it.

Stage of economic cycle: in recession, budget deficit will increase AD, close negative output gap.

Automatic stabilisers: if these are strong, there is less of a need for ↑ gov. spending.

Policies to reduce inflation

Contractionary fiscal/ monetary policy: reduce AD + therefore demand pull inflation

Supply side policies: increase AS + therefore decrease cost push inflation

Policies to reduce current account deficit

Contractionary monetary policy: lower inflation→more internationally competitive (cheaper) exports→exports increase→current account increases

Supply side policy: lower LR cost of production→boost export competitiveness →current account increases

Policies to reduce income inequality

Expansionary fiscal: ↑ gov. spending on benefits

Expansionary fiscal: ↓ regressive taxation

Macroeconomic tradeoffs

Expansionary fiscal + monetary policy(+vice versa)

-phillips curve

+growth ↑, unemployment ↓, income inequality ↓

-inflation ↑, CA position, gov. finances, environment ↓

EVALUATION

Size of output gap: smaller output gap→higher inflation+lower growth.

Policy used: different tradeoff based on different policy used.

Supply side policies

+growth ↑ ,unemployment ↓, inflation ↓, CA position improves

EVALUATION

Size of output gap: if output gap is large(recession), supply side policies are useless in meeting objectives.

Gov. finances: interventionist policies may damage gov. budget.