2.6 Macroeconomic Objectives and Policies

Demand-side policies

Strategies which aims to increase (expansionary policy) or decrease (contractionary policy) aggregate demand

Types of demand-side policies

Fiscal policy

Monetary policy

Fiscal policy

A policy implemented by the government, with the main instruments being government spending and taxation

Expansionary fiscal policy

G↑ or T↓ = AD↑; this creates a budget deficit = fiscal deficit = government deficit

Expansionary fiscal policy helps achieve economic growth, lower unemployment, and an improvement in a government’s long-run finances (as they spend less on benefits)

Contractionary fiscal policy

G↓ or T↑ = AD↓; this creates a budget surplus = fiscal surplus = government surplus

Contractionary fiscal policy helps achieve a trade surplus, better environmental standards, controlled inflation and an improvement in a government's short-run finances (but long-run finances become worse as RDGP falls)

Ricardian equivalence (evaluating a change in government spending)

If government spending rises, consumers and firms will expect higher taxes in the future (e.g. during COVID, when Rishi Sunak announced the furlough scheme, business papers and analysts immediately predicted future tax increases)

As a result, consumers and firms will start saving to cover lower expected disposable income in the future

Therefore, whilst government spending rises, consumption falls, hence, there is no change in AD (consumption and government spending cancel each other out)

If government spending falls, consumers and firms will expect lower taxes in the future

As a result, consumers and firms will start spending to cover higher expected disposable income in the future

Therefore, whilst government spending falls, consumption rises, hence, there is no change in AD (consumption and government spending cancel each other out)

Ricardian equivalence (evaluating the volatility of the trade cycle)

The fiscal policy may actually make the trade cycle more volatile because there is a delay in the government receiving information about the state of the economy and, therefore, a delay in action

The government should decrease AD at point A, but due to information delays, the government would intervene at point B, when the economy is already deflating, increasing the size of the recession

The government should increase AD at point C, but will end up doing so at point D, increasing the rate of the boom/recovery

Monetary policy

A policy implemented by the Central Bank (Bank of England), not the government, with the main instruments being interest rates and quantitative easing/tightening

Monetary policy - interest rates

Changes in interest rates are used to manipulate AD in order to achieve certain macroeconomic objectives

Interest rates↓ = AD↑ = economic growth↑, employment↑ and government finances↑ (expansionary fiscal policy)

Interest rates↑ = AD↓ = controlling inflation, trade balance improves and environmental damage↓ (contractionary fiscal policy)

How do interest rates impact AD

Interest rates work through a process called the transmission mechanism; it describes three routes by which a change in the Central Bank’s interest rates is transmitted through to the wider economy

Interest rates - route 1

Interest rates↓ = cost of borrowing↓ = incentive to borrow↑ = consumption on big-ticket items↑ = C↑ = AD↑ OR interest rates↓ = reward for saving↓ = incentive to save↓ = C↑ = AD↑

Interest rates - route 2

Interest rates↓ = cost of borrowing↓ = incentive to borrow to invest in capital spending↑ (Thomas Piketty) = investment↑ = AD↑ OR interest rates↓ = reward for saving↓ (firms save to provide insurance against future costs, e.g. AI, war and global uncertainty) = incentive to save↓ = C↑ = AD↑

Interest rates - route 3

Interest rates↓ = reward for saving in the domestic economy relative to other economies↓ = inward ‘hot money’ flows↓ (fewer people are saving in the UK) = demand for the domestic currency↓ OR outward ‘hot money’ flows↑ (more UK citizens are saving elsewhere so they ‘sell’ the pound to buy other currencies) = supply for the domestic currency↑

Inward ‘hot money’ flows↓ and outward ‘hot money’ flows↑ = currency prices↓ (depreciation) = export prices↓ and import prices↑ OR quantity demanded of exports↑ and quantity demanded of imports↓ OR exports↑ and imports↓ = trade deficit↓ = AD↑

Evaluating the usefulness of interest rates

Time lag; once interest rates are altered, it can take 6 to 24 months for the transmission mechanism to work, leading to a delayed effect on AD

Dependent on confidence; low interest rates do not work well if confidence in the economy is low, as consumers/firms may not want to borrow (even at low interest rates) if they think the economy will perform poorly in the future (incomes fall); high interest rates do not work well if confidence is too high, as consumers/firms may still want to borrow (even at high interest rates) if they think the economy will perform well in the future (incomes rise)

Zero-lower bound (only for expansionary fiscal policy, interest rates↓); once interest rates are close to 0, it is very difficult to decrease them significantly further, as this would mean negative interest rates, which would be an experimental policy with little historical precedent, very difficult to know the impact; therefore, once interest rates approaches 0, central banks only allow very small decreases which means interest rate policies ceases to have a substantial impact

Dual-economy problem; occurs when different areas/regions of the same economy are at different stages of the trade cycle (e.g. London needs interest rates to rise to help reduce inflation and the cost of living, however Middlesbrough needs interest rates to fall to increase AD and generate jobs/growth), however, the Central Bank can only set the interest rate, so they cannot help both London and Middlesbrough

Monetary policy - quantitative easing/tightening

Quantitative easing is the response to the failure of low interest rates; often used to stimulate recovery and resolve the zero lower bound problem

It is an unconventional form of monetary policy; it was first used by the Japanese Central Bank in 1997 as a response to the Asian financial crisis

How does quantitative easing impact AD

Quantitative easing aims to increase demand by increasing liquidity in the financial system; by increasing liquidity through increasing the amount of cash circulation, more borrowing and spending can take place, this is useful when banks have cut their cash reserves or are scared to lend them out

Stages of a quantitative easing programme

The Central Bank creates new money electronically

The Central Bank uses the money to buy bonds and other illiquid assets from other financial institutions

Therefore, other banks have liquid cash that they can lend to consumers/firms, and the Central Bank has taken illiquid assets (that can’t be lent out) out of the financial system

Evaluation for quantitative easing

Share prices; since the implementation of quantitative easing, GDP per capita has increased by roughly 6.25% in the UK, over the same period, UK stock markets (e.g. FTSE 250) have risen by 130%, this may suggest that the new money created by the Bank of England was not used for lending to everyday households and businesses, but into financial assets such as shares; this has pumped up share prices without increasing the average incomes, leading to inequality widening with little increase in growth

Quantitative easing programmes may lead to inflation or hyperinflation using Fisher’s equation of exchange (MV=PT or MV=PQ); an increase in the money supply can lead to the price level increasing (assuming the velocity of spending and quantity of transactions are constant)

Quantitative easing may not work if there is a lack of confidence in the financial system; if this is the case, banks may keep the new cash in reserve rather than lend it out, in which a little increase in AD occurs

Strengths of fiscal policy/weaknesses of monetary policy

It does not rely on business/consumer confidence, as the government directly increases/decreases their spending, guaranteeing more or less total spending; Keynes argued that this is essential to manage the economic cycle, because confidence will always be low in a recession and high in a boom (Keynesian demand management)

Avoids the dual economy problem as fiscal policy can be targeted at different areas of the economy

Weaknesses of fiscal policy/strengths of monetary policy

The government may be affected by politics and may do what is popular rather than what is good for the economy (e.g. cut taxes in a boom)

Fiscal policy has a longer time lag than monetary policy, as fiscal decisions must go through the political process; fiscal policy has a greater inside time lag (time between deciding the policy and implementation), and both fiscal and monetary policy have the same outside time lag (time between implementation and effect) therefore, fiscal policy has a greater time lag overall

Monetary Policy Committee (MPC)

9 members of the Bank of England who decide interest rates, meet 8 times a year, and vote whether to change interest rates or by how much

Role of the Central Bank

The Central Bank is a bank to other banks, a bank to the government, and is known as the lender of the last resort (can lend money if all other banks run out)

Supply-side policies

Government strategies which aims to increase an economies productive capacity (aggregate supply/long-run aggregate supply)

Supply-side policies with a Keynesian LRAS diagram

Supply-side policies may be ineffective with a Keynesian LRAS diagram as there would be no effect

Types of supply-side policies

Market-based policy

Interventionist policy

Market-based policies

A policy implemented by the government, with the main policies including deregulation, privatisation, and cutting taxes/benefits (incentive-based policies)

Market-based policies - deregulation

When the government removes regulations previously imposed on firms (e.g. financial market deregulation in the UK/US in the 70s/80s, under Margaret Thatcher and Ronald Reagan respectively; may also apply to labour markets, e.g. reduced regulations on hiring/firing workers)

Decreased regulations = lower barriers to entry = more competition = improved efficiency/productivity = more output for every input (i.e. more efficient capital) = higher quality of capital = increased LRAS

Decreased regulation = lower cost of production (e.g. compliance costs) = more profit = more investment in new capital = increased capital stock in the economy = higher quantity of capital = increased LRAS

Evaluation for deregulation

Market-based policies - privatisation of national industries

When the government sells state-owned assets (e.g. the NHS) to private investors or healthcare

Increased privatisation = competition + profit motive (the government has no profit motive and has no free competition) are introduced into the market = improved efficiency/productivity = more output for every input (i.e. more efficient capital) = higher quality of capital = increased LRAS

Unlike interventionist policies, selling state assets will make the government extra money to reduce national debt, rather than requiring additional spending

Evaluation for privatisation of national industries

It may result in a private monopoly or a highly concentrated industry where a few firms dominate, which may result in higher prices for consumers and an inability for them to access crucial services (e.g. Thames Water or the National Rail)

Privatisation has often been criticised for undervaluing the assets and selling them to private investors too cheap, leading to a poor return for the government and an easy profit for investors

Market-based policies - incentive based policy

When the government lowers income tax and/or lowers welfare or unemployment benefits

The idea is to encourage people to work instead of being unemployed/inactive

Lower income tax = higher disposable income for employed workers = higher opportunity cost of unemployment = greater incentive for workers to join the labour force = higher quantity of labour = increased LRAS

Lower welfare/unemployment benefits = lower disposable income for those unemployed/inactive = greater incentive for workers to join the labour force = higher quantity of labour = increased LRAS

Interventionist policies

A policy implemented by the government, with the main policies including education, infrastructure and research and development

Interventionist policy - spending on public education

Improved education = improved skills = improved productivity = more output for every input (i.e. more efficient workers) = higher quality of labour = increased LRAS

Evaluation for spending on education

National debt/opportunity cost of government spending

Time lag; education takes a long time to impact the economy

Education is a positional good (the utility gained decreases as more people have it), so if too many people get a university degree, the value of the qualification decreases, and the impact on the economy decreases

There needs to be demand for the skills schools teach; under Mugabe in Zimbabwe, the government spent on education to increase literacy rates to one of the highest in Africa; however, unemployment rates were only average compared to the rest of the continent

Interventionist policy - spending on infrastructure

Improved infrastructure = improved transport time/quantity = improved productivity = more output for every input (i.e. more efficient capital) = higher quality of factors of production = increased LRAS

Evaluation for spending on infrastructure

National debt/opportunity cost of government spending

Time lag; infrastructure takes a long time to develop

Infrastructure spending may end up in ‘white elephant projects’, a phrase used to describe a project that initially seems impressive but is actually not particularly useful, practical or affordable (e.g. Ciudad Real International Airport or Boris Johnson Garden Bridge)

Interventionist policy - spending on research and development

Increased research and development = improved technology = improved productivity = more output for every input (i.e. more efficient capital) = higher quality of factors of production = increased LRAS

Evaluation for spending on research and development

National debt/opportunity cost of government spending

Time lag; research and development takes a long time to undergo

The fishing-out effect vs standing on shoulders effect (Paul Romer); fishing-out in research and development means too many researchers are allocated to one field or area with little gains in knowledge generated (e.g. consciousness science), meaning additional research spending is typically wasted; the standing on shoulders effect may counter this however, as this describes

Conflicts between objectives/policies - the Phillips Curve

As an economy moves along the Phillips Curve (SRPC), it trades off controlling inflation with higher unemployment; from A to B, reducing inflation conflicts with increased unemployment; from B to A, reducing unemployment conflicts with increased inflation

The Phillips Curve relationship can also be modelled with AD shifts

The Phillips Curve is not a theoretical model (unlike AD/AS); it is based on real data (UK unemployment and inflation rates, from 1851 to 1957); this is an empirical model (based on observed data)

Evaluation of the Phillips Curve

Milton Friedman famously predicted that both high inflation and unemployment are possible (or both low); i.e. not always a negative relationship

Friedman’s long-run Phillips Curve (LRPC) model predicted UK stagflation in the 1970’s, demonstrating that the SRPC trade-off does not always apply