Economics HL - Macroeconomic Policies

Macroeconomic Objectives

• Economic Growth: Increase real GDP over time.

• Low Stable Rate of Inflation: Maintain manageable and predictable price levels.

• Low Unemployment: Minimize joblessness to utilize productive capacity.

• Sustainable Level of Debt: Ensure public debt remains manageable long-term.

• International Stability and Competitiveness: Balance trade, currency stability, and global competitiveness.

• Equitable Society: Reduce inequality through policies like progressive taxation and welfare.

Fiscal Policies (Direct Taxes): Definition

use of government spending and taxation to influence the economy (economic activity, employment, inflation)

Fiscal Policies: Contractionary ←

typically implemented to:

• reduce inflationary pressures

• stabilize the economy

• prevent excess economic growth from causing overheating (limit of capacity)

to get to:

• full employment

• low sustainable rate of inflation

Fiscal Policies: Expansionary →

• government expenditure increases

• reduction in taxes to stimulate economic growth

• boost aggregate demand

• encourage investment

• reduce unemployment

• used during periods of economic slowdown or recession

Fiscal Policy: Types

• Income Tax: Levied on personal income (wages, rent, dividends). Primary revenue source for governments.

• Corporation Tax: Direct tax on business profits.

• Capital Gains Tax: Applied to profits from investments (e.g., stocks, property).

• Inheritance Tax: Tax on wealth transferred between individuals (e.g., bequests).

• Windfall Tax: One-time levy on unexpected gains (e.g., lottery wins, corporate takeovers).

Fiscal Policy: Goals

• Maintain low, stable inflation.

• Achieve low unemployment (full employment).

• Stabilize economic fluctuations (reduce business cycle volatility).

• Promote equitable income distribution.

• Ensure external balance (manage trade deficits/surpluses).

• Balance the budget and manage public debt.

BUDGIE:

• Business cycle fluctuations (stabilize)

• Unemployment (full unemployment)

• Distribution of Income (equitable distribution)

• Growth (👍)

• Inflation (low and stable)

• External Balance (ensure, manage trade deficits/surpluses)

Monetary Policy: Definition

actions by a central bank to control the money supply and interest rates to achieve macroeconomic objectives

Monetary Policy: Goals

• Primary Goal: Maintain price stability (control inflation).

• Secondary Goals: Promote sustainable growth, reduce unemployment (dual mandate in some countries).

Key Proponents: Keynesian economists advocate using monetary policy to stimulate demand during recessions.

Monetary Policy: Tools

1. Interest Rates:

   • Base Rate/Discount Rate: Central bank sets benchmark rates; influences borrowing costs.

     • Lower rates → Cheaper loans → ↑ Consumption (C) & Investment (I) → ↑ AD.

     • Higher rates → Discourage spending → ↓ AD.

2. Open Market Operations (OMOs):

   • Buying/selling government bonds to adjust money supply.

     • Buy bonds → Inject liquidity → ↑ Money supply → ↓ Interest rates.

     • Sell bonds → Reduce liquidity → ↓ Money supply → ↑ Interest rates.

3. Reserve Requirements:

   • Mandate the % of deposits banks must hold (not lend).

     • Lower reserves → Banks lend more → ↑ Money supply.

4. Quantitative Easing (QE):

   • Central bank purchases long-term securities to inject liquidity during crises

Monetary Policy: Expansionary →

• Goal: Stimulate AD during recessions (close deflationary gap).

• Actions: ↓ Interest rates, ↑ Money supply via OMOs/QE.

• Impact: AD shifts right → ↑ Real GDP, ↑ Employment.

• AD1 → AD2 → Real GDP rises (Y1 → Y2), price level ↑ (P1 → P2).

Monetary Policy: Contractionary ←

• Goal: Reduce AD during high inflation (close inflationary gap).

• Actions: ↑ Interest rates, ↓ Money supply via bond sales.

• Impact: AD shifts left → ↓ Inflation, ↓ Overheating.

• AD1 → AD2 → Real GDP falls (Y3 → Y2), price level ↓ (P2 → P1)

Real Interest Rate = Nominal Rate - Inflation Rate

Real Interest Rate = Nominal Rate - Inflation Rate

Keynesian Multiplier Effect: Definition

how an initial injection of government spending into the economy leads to a larger increase in Aggregate Demand (AD) and Real GDP due to repeated rounds of spending

Marginal Propensity to Consume (MPC)

MPC = Δ Income / Δ Consumption

• proportion of income spent on consumption

• for ever dollar earned, percentage of dollar you spend

100% of Income

MPC + MPS + MPI + MPT = 1 (100% of income)

• Marginal Propensity to (Consume + Save + Imports + Tax) = 1

Spending Multiplier

Spending Multiplier = 1 / (1 - MPC)

Example:

• Initial injection = $100 million.

• Leakages: 10% saved (MPS), 10% imports (MPI), 20% taxes (MPT) → Total leakages = 40%.

• MPC = (1 - 0.4) = 60%

• Multiplier = 1 / (1-0.6) = 2.5

Total AD Increase: 100 million × 2.5 = 250 million

Tax Multiplier

Tax Multiplier = MPC / MPS = MPC / (1 - MPC)

Q²CELL

Quantity and Quality of Capital, Enterprise, Land, Labor

Quality of Labor

• Higher population growth or immigration increases the workforce.

• Better education, training, and skill development improve labor productivity.

• Investment (spending money on capital goods: tech, R&D, new factories, machine upgrades

• Increasing quality and quantity of capital and improving the productive efficiency

Quantity of Labor

• Immigration: increase size of the labor force (labor force includes unemployed so not unemployed becoming employed)

• Incentives: benefits, cutting income tax

Technological Advancements

• Innovations in production methods boost efficiency and output.

• Automation and AI reduce costs and increase productivity.

Long-Run Aggregate Supply (LRAS)

• Vertical curve at full employment output.

• Reflects the economy’s productive capacity, unaffected by price levels.

LRAS: Rightward Shift

• Q²CELL = Quantity and Quality of Capital, Enterprise, Land, and Labor

Improved technology, education, infrastructure, resource discoveries, immigration, competition (deregulation)

LRAS: Leftward Shift

• Huge decrease in labor productivity

• Mass capital depreciation

• War, conflict, natural disaster → destroys infrastructure → reduces quantity of capital

• Death → reduces quantity of labor

• Health crisis → affects productivity and quantity of labor

• Hysteresis = long-term unemployment where workers become discouraged

• When workers leave the economy → reduce the quantity of labor

Natural disasters, wars, capital depreciation, health crises, reduced labor productivity

Neo-Classical Model: Flexible Wages

Markets self-correct through flexible wages and prices. Temporary rigidities exist, but long-run equilibrium restores full employment without government intervention.

Keynesian Model: Sticky Wages

Wages do not adjust quickly, leading to prolonged unemployment.

• fire > cut wages (demotivated, less productive)

Deflationary Gap ◀

AD < full employment output (LRAS), causing unemployment

• Deflationary gaps result in unemployment and potential deflation (if prices are flexible)

Inflationary Gap ▶

AD > full employment output, causing rising prices

• Inflationary gaps drive price increases (demand exceeds capacity)

Full Employment

• Maximum sustainable output using all factors of production efficiently

• Includes natural unemployment (e.g., workers transitioning jobs)

Indirect Taxes

Indirect tax is the tax levied on the consumption of goods and services (not directly levied on the income of a person)

• Sales Tax (VAT): charge the manufacturing, sale, and consumption

• Carbon Tax: imposed on firms producing excessive carbon emissions to discourage pollution

Nominal GDP: Calculation

• value of final goods and services evaluated at current-year prices

• Ex: NGDP₂₀₁₀ = Q₂₀₁₀ x P₂₀₁₀

Limitations:

• Prices distorts data, only shows cases where the prices goes up

• Unsure if the market is PRODUCING more

Real GDP: Calculation

• use base year prices and current quantities to calculate

• Ex: NGDP₂₀₁₁ = Q₂₀₁₁ x P₂₀₁₀

GDP Growth Rate: Calculation

Percent Change = %Δ

[(New Value - Old Value) / (Old Value)] x 100%

GDP Deflator: Calculation

• Nominal GDP / Real GDP x 100%

• Unitless, just a number

GDP Deflator = [(NGDP) / (RGDP)] x 100%

Inflation Rate: Calculation

Inflation Rate = [(GDP_current - GDP_past) / (GDP_past)] x 100%

• Ex: [(GDP₂₀₁₁ - GDP₂₀₁₀) / (GDP₂₀₁₀)] x 100%

Aggregate Demand (AD): Rightward Expansion

Good:

• ↑ employment

• GDP ↑

• Incomes ↑

• Standard of living ↑

Not-so-Good:

• Inflationary gap ↑

• Average price level ↑

• Deficit spending → debt ↑ → interest ↑

• Unsustainable, beyond potential

  • Fixed amount of FoPs, producing beyond full employment → more demand but for same amount of FoPs

  • Demand > Supply

  • Can temporarily increasing GDP

  • Prices going up