2.6.1 Possible macroeconomic objectives & 2.6.2 Demand-side policies

What are the 7 possible macroeconomic objectives

1) Economic growth

2) Low unemployment

3) Low & stable rate of inflation

4) Balance of payments equilibrium on current account

5) Balanced government budget

6) Protection of the environment

7) Lower income inequality

Distinction between monetary & fiscal policy

• Monetary: policy by Central Bank, change cost/amount of money to affect AD

• Fiscal policy: policy by government, change government spending/borrowing & tax revenue to affect AD

Fiscal policy instruments: government spending & taxation / Distinction between government budget (fiscal) deficit & surplus

• Balanced government budget: government spending = tax revenue with no budget deficit nor a budget surplus

• Budget deficit / fiscal deficit = government spending exceeds tax revenue

• Budget surplus / fiscal surplus = government spending is lesser than tax revenue

Distinction between, and examples of, direct & indirect taxation

• Direct tax = tax on income, for example, corporation tax (tax on firm’s profits), income tax, national insurance, business tax, council tax

• Indirect tax = tax on goods/services, for example, VAT (firms pay when consumers pay their products)

Use of AD/AS diagrams to illustrate demand-side policies (just for fiscal for now)

For Fiscal policy

• change government spending - shift of AD curve - economic growth

• change in tax revenue caused by change in direct tax/indirect tax

  • direct tax - (ie. affect disposable income) shift AD curve - economic growth / inflation

  • indirect tax - shift SRAS curve (firm’s cost of production) - economic growth / inflation

2 goals of Demand side policy

• Expansionary (AD increases)

• Contractionary (AD decreases)

• Both are shown by shifts in AD or extension or contraction of AD

• Expansionary is targeting economic growth objective

• Contractionary is targeting inflation or budget deficit to reduce debt

Common chain of reasoning for corporation tax on the AD/AS diagram (Direct tax)

• Corporation tax increases = tax on profits of firms increases = firms have less profits = less incentivized to invest = Investment decreases = AD decreases = Contractionary = inflation decreases / economic decline

Common chain of reasoning for VAT on the AD/AS diagram (Indirect tax)

• VAT increases = tax on g&s on producer increases = cost of production increases = SRAS decreases = AD contracts = Contractionary = Price level increases = inflation increases

Strengths & weaknesses of demand-side policies (EVALS)

• Take long time to work?

• Very expensive?

• Does it affect other objectives?

Meaning of discretionary fiscal policy

When there are deliberate changes in government spending or taxes which can result in either expansionary / Contractionary

Monetary policy instruments: Interest rates

• This is where the Central Bank (ie. Bank of England) changes the base rate of interest

• (Base rate of interest = rate at which commercial banks pay back to the Central Bank for borrowing money)

• Aim of this interest rate policy (increasing interest rates) is to eventually lower rate of inflation (if inflation rise above 2%)

  • 1) Increase base rate of interest by the Central Bank

  • 2) Which eventually leads to lower rate of inflation

Monetary policy instruments: asset purchases to increase the money supply (quantitative easing)

Quantitative easing = It’s when a central bank (ie. Bank of England) buys government bonds to increase money supply in the economy

• Used when interest rates policies alone cannot stimulate AD as it is already very low

The role of the Bank of England: the role & operation of the Bank of England’s Monetary Policy Committee

• The job of the MPC of the Bank of England is to change the base interest rate if inflation is too high

Strengths & weaknesses of monetary policy

• Affect other objectives

  • If interest rates rise → inflation decreases → GDP decreases → production decreases → need less workers → unemployment increases

  • If interest rates fall: opposite effect to the above

• Effects on certain groups

  • Effect on households: If interest rates rise → mortgages (a type of loan) for households more expensive → take up more income → disposable income to spend on necessities decreases → reduces standard of living / don’t have enough money to spend on mortgages anymore → homeless

  • Effect on savers: If interest rates fall → savings have a lower return for existing savings → MPS decreases → banks have less money to lend loans to ppl / decreases money to use in recessions as wages go down

• Time lag

  • It can take up to 18 months for an interest rate change to have its full effect

  • When interest rates change, borrowing/spending don’t adjust instantly

    • Households: Interest rates may have been fluctuating so they might wait to be certain enough that it will become stable ; households on a fixed-rate mortgages so their payments don’t change until the fixed term ends

    • Firms: they might already have enough cash for now so don’t need to borrow immediately