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: Definition

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

• Government Spending (G): Infrastructure, education, healthcare.

• Taxation (T): Income tax, corporate tax, VAT.

Evaluation

• Automatic stabilizers: Unemployment benefits (↑ in recession), progressive taxes.

• Keynesian multiplier: 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

• Government spending → GDP growth (if spare capacity).

Fiscal Policy: Pros

✅ Pros:

• Quick impact (especially spending).

• Direct job creation (e.g., infrastructure projects).

• Can target inequality (progressive taxes, welfare).

Fiscal Policy: Cons

❌ Cons:

• Crowding out effect (govt borrowing ↑ → private investment ↓).

• Time lags (delays in implementation).

Risk of budget deficits if overused.

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

Central bank actions to control money supply & interest rates

• Interest Rates:

  • ↓ Rates → Cheaper loans → ↑ C + I → AD ↑.

  • ↑ Rates → Costlier loans → ↓ C + I → AD ↓.

• Quantitative Easing (QE): Buying bonds to inject money into the economy.

• Reserve Requirements: Adjusting bank reserve ratios.

Monetary Policy: Pros

✅ Pros:

• Quick implementation (no legislative delays).

• Independent central banks reduce political bias.

Monetary Policy: Cons

❌ Cons:

• Liquidity trap (interest rates near 0% → ineffective).

• Time lags (takes ~18 months to fully affect economy).

• Can worsen inequality (asset prices ↑ benefit the wealthy).

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)

Market-Based Supply-Side Policies: Definition

Policies to increase efficiency & LRAS by reducing government intervention.

• Deregulation: Reducing business restrictions (e.g., Uber vs. taxis).

• Privatization: Selling state-owned firms (e.g., British Rail).

• Labor Market Reforms:

  • ↓ Minimum wage → More hiring.

  • ↓ Unemployment benefits → Incentivize work.

• Tax Cuts: Corporate tax cuts to boost investment.

Market-Based Supply-Side Policies: Pros

✅ Pros:

• ↑ Competition → Lower prices, better quality.

• Encourages innovation & entrepreneurship.

Market-Based Supply-Side Policies: Cons

❌ Cons:

• ↑ Inequality (e.g., lower wages, reduced worker rights).

• Short-term unemployment (e.g., firms cut costs).

Interventionist Supply-Side Policies: Definition

Government-led policies to boost productivity & LRAS.

• Education & Training: Upskilling workforce (e.g., Germany’s apprenticeships).

• Infrastructure Investment: Roads, broadband (e.g., China’s Belt & Road).

• Industrial Policy: Subsidies for R&D (e.g., US CHIPS Act for semiconductors).

Interventionist Supply-Side Policies: Pros

✅ Pros:

• Corrects market failures (e.g., underinvestment in education).

• Long-term growth ↑ (human capital & infrastructure).

Interventionist Supply-Side Policies: Cons

❌ Cons:

• Expensive (higher taxes or borrowing).

• Risk of government failure (misallocation of funds).

Demand-Side vs Supply-Side

Crowding Out: Definition

• Government crowds out the private sector (loanable funds and interest rates)

• when government borrowing reduces the level of private investment in the economy

Occurs when the government attempts to stimulate the economy by increasing government expenditure on infrastructure

• G↑ → GDP↑ but private investment↓

Crowding Out: Gov-Funded Expressway Example

• Must run a budget deficit and finance its increased spending in some way

• increase in government expenditure (G) on road building will shift out the aggregate demand curve from AD₁ to AD₂, increasing the price level from P₁ to P₂ and increasing real output from Y₁ to Y₂

Crowding Out: Domestically-Borrowed Expressway Example

• Sell bonds and compete directly with the private sector in the loanable funds market

  • Loanable funds market = where potential investors are able to obtain money or funds for investment projects. Investors weigh up the cost of borrowing money (the interest rate) against the expected return on their investment. If the interest rate is low, and the expected return from the investment is high, then the potential investor is likely to borrow the funds.

• Competition will drive the interest rate from i₂ to i₂

  • As interest rates rise, firms may find it too expensive to invest in projects → overall investment in the economy will fall

  • Decrease in investment (I) will shift AD₂ to AD₃, which is crowding out

  • Price level will fall from P₂ to P₃ and output will fall back from Y₂ to Y₃

• Crowding out depends heavily on the interest rate change

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