2.6 Macroeconomic Objectives and Policies

Demand-side policies

Government 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, higher employment, and an improvement in the 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, short-run government finances to improve (but long-run finances become worse as RDGP falls), and it helps control inflation

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 to stimulate recovery and 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)

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)

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