Macroeconomic Policies

IB SL Economics Macroeconomic Policies & Definitions

Monetary Policy

Use of interest rates and money supply in order to influence aggregate demand

Contractionary monetary policy

Central Bank increases interest rates in order to decrease aggregate demand

Expansionary monetary policy

Central bank decreases interest rates (or increases money supply) in order to increase aggregate demand

Quantitative easing

Where the central bank creates new money and uses this money to buy government bonds from financial institutions → this should increase lending by the financial sector which should push down interest rates

Goals of monetary policy

1) Low and stable inflation

2) Low unemployment

3) Reduce business cycle fluctuations

Real interest rate

Nominal interest rate adjusted for inflation

Strengths of monetary policy

1) Shorter time lags

2) Can be incremental, flexible and easily reversible

3) Central bank independence

Constraints on monetary policy

1) Limited scope of reducing interest rates when they are close to zero

2) Not very effective in a recession when consumer and businesss confidence is low

Fiscal policy

Use of government spending and taxation to influence aggregate demand

Expansionary Fiscal policy

Increase government spending and/or decreases taxation

Contractionary fiscal policy

Decrease government spending and/or increase taxation

Progressive Tax

As income increases, the proportion of income paid in tax also increases

Proportional tax

As income increases, the proportion of income paid in tax stays the same

Regressive tax

As income increases, the proportion of income paid in tax decreases

Capital expenditure

Spending by the government on infrastructure, machinery and other capital goods

Current expenditure

Refers to the governments day to day spending on final goods and services

Transfer payments

Payments made by the state to individuals without there being any exchange of goods or services

Goals of fiscal policy

1) Low and stable inflation

2) Low unemployment

3) Reduce business cycle fluctations

4) Promote an equitable distribution of income

Advantages of expansionary fiscal policy

1) Will increase real GDP and reduce unemployment (very effective in a deep recession)

2) Fiscal policy can be targeted at particular sectors or regions of the economy

Constraints on the effectiveness of expansionary fiscal policy

1) Negative effect on government finances

2) Usually time lags involved

3) Political pressures

Supply-side policies

Policies that aim to increase the productive capacity of the economy

Interventionist Supply-Side Policies

Government seeks to directly bring about an increase in the quantity or quality of factors of production

Examples of interventionist SSPs

1) Spending on education and training

2) Improving quality, quantity and access to healthcare

3) Provision of infrastructure

4) Government spending on research and development

5) Industrial policies (support and subsidies for infant industries)

Market-based Supply-Side Policies

Policies that allow markets to operate more freely and therefore increase both the incentive for labour to work harder and the incentive for firms to invest

Incentive-related policies (Market-Based SSPs)

a) Reductions in income tax

b) Cuts in businesss tax and capital gains tax

Labour market policies (Market-based SSPs)

a) Reducing the power of trade unions

b) Reducing unemployment benefits

c) Abolishing (or reducing) minimum wages

Policies to encourage competition (Market-based SSPs)

a) deregulation

b) Privatisation (to increase the profit motive)

c) Trade liberalization

d) Anti-monopoly regulation

Advantages of Market-based SSPs

1) should help to reduce the natural rate of unemployment

2) Tends to be less costly for the government to implement compared to interventionist policies

3) Involves shorter timelags than interventionist SSPs

Disadvantages of Market-based SSPs

1) Involves removing protections from the most vulnerable

2) Increases income inequality

Advantages of interventionist SSPs

1) Increases potential output of the economy in the long-run and reduces inflation

2) Government provides investment that would be underprovided by the free market

Disadvantages of interventionist SSPs

1) Very long time lags

2) Very costly

3) Effectiveness of SSPs is uncertain

Goals of SSPs

1) Long-term growth by increasing productive capacity

2) Improving competition and efficiency

3) Reducing labour costs and unemployment through labour market flexibility

4) Reducing inflation to improve international competitiveness

5) Increases firm’s incentives to invest in innovation by reducing costs

Fiscal deficit

G > T (Government has to borrow money by issuing govt bonds)