Econ 2.6 policies

What are the macroeconomic objectives

Low unemployment

Low and stable inflation

Economic growth

Balance of payment equilibrium

Other macroeconomic objectives

Balance of government budget

Protection of the environment

Greater income equality

Demand side policy

Policies used to manipulate consumer demand

Expansionary policy

Used to increase AD

Normally during a recession

Deflationary policy

Used to decrease AD to control inflation

Fiscal policy

The use of borrowing, government spending, and taxation to manipulate the level of aggregate demand

Taxation

The three taxes that the governments manipulate are income tax, corporation tax, and VAT

What are the 2 main ways governments can influence AD using the fiscal policy

A rise in income tax will lead to a fall in disposable income, and therefore a reduction in consumption

or rise in corporation tax will lead to a fall in profits and therefore a fall in investment

Or rise in government spending will increase AD

Expansionary fiscal policy

Increasing levels of government spending more than taxation to stimulate AD during a downturn in economic activity

Contractionary fiscal policy

Increasing levels of tax revenue more than government spending to decrease AD during a boom when AD is outstripping productive capacity

Economic effects of expansionary fiscal policy

AD shifts to the right

Positive multiplier effect

Jobs created/Incomes increase

Increase spending

Increased consumption

Increases AD

Real output increases

Price levels increase

Economic growth

Economic impacts of contractionary fiscal policy

Ad shifts left

Negative multiplier effect

Decreased spending/wages decrease

Rise in unemployment

Fall in income

Real output decreases

Price levels rise

Factors effecting the fiscal policy

Size of multiplier

Where AD intersects AS

Time lags - taxes take several months to see changes in

Implementation lags

LRAS is inelastic so an increase in AD will just increase inflation

How likely consumers are to spend their extra income on imports instead of domestic goods

Direct taxation

Taxes paid directly to the government by an individual taxpayer

Indirect taxation

Where the person charged with paying the money to the government is able to pass that cost onto someone else

Examples of taxes

Income tax roughly makes up 25 percent of government revenue. The base rate is 20% and then 40

VAT is 20%

Problems of fiscal policy

May create a budget deficit - expansionary fiscal policy

Government spending may also impact LRAS - decreasing gov spending could decrease the quality of services

Increasing taxes to reduce AD may cause disincentives to work which would lead to a fall in AS

May cause delayed spending as people are anticipating higher prices speculation

Demand pull inflation would cause export demand to fall

Monetary policy

Controlling the macro economy by changes in money supply and interest rates

What is the repo rate

The price the central bank will charge for short term loans to other financial institutions

A change in the repo rate will effect the rates banks charge for loans to consumers

Why does a rise in interest rates cause a fall in AD

Increased cost of borrowing for consumers and firms

Fall in investment and consumption

Consumer/ mortgage repayments increase

AD falls

Asset prices

Lower interest rates

Lower cost of borrowing

Lower reward for saving

Increased firm investment

More purchasing of assets Eg houses

Boost in AD

Asset prices also increase in value

Confidence

Increased interest rates

Decreased confidence

Fall in consumption and investment

Loans and mortgages become more expensive

Less disposable income

Fall in AD

Exchange rates

Higher interest rates

Foreigners increase incentive to invest in British banks

Increase demand for pounds

Value of pound increase

Imports become cheaper

Exports become more expensive

Net trade decreases

AD falls

Evaluation of monetary policy

May lead to a trade deficit - exports fall significantly

Time lag - changes to interest rates take time to work

Increase debt culture

High interest rates over a long period of time will discourage investment and lead to a fall in LRAS

Quantitative easing

The central bank buys government bonds to increase money supply

Banks now have an incentive to lend more to businesses and households

Thus acts as a stimulus for boosting Ad

Liquidity trap

When interest rates are at a near zero, but AD is still not being stimulated because

Consumers are worried about the economy

Firms are in high levels of debt

Firms lack confidence to invest

What are bank reserves

Deposits that the central bank holds in accounts at the Bank of England

How can the Bank of England encourage banks to lend using reserves?

It can increase the reserves in banks’ accounts, giving them more liquidity so they are able to lend more.

What alternative method did the Bank of England use for QE

It bought securities/bonds from private sector institutions such as pension funds, insurance companies and banks.

Why does buying bonds increase spending in an economy

Investors may reinvest in the economy, increase liquidity, investment and AD

How does QE increase AD

Since the bank is buying assets

Asset prices rises

Creates a positive wealth effect

Consumption rises

Cost of borrowing decreases

Higher asset prices means lower yields

Increased consumption and investment

Problems of quantitative easing

Can lead to high levels of inflation/ hyperinflation

There is no guarantee that higher asset prices will lead to higher consumption

Supply side policies

Government policies aimed at increasing the productive potential f the economy

Market based policies

Policies that are designed t remove anything that ensures the free market operates efficiently

Interventionist policy

Policies that are designed to correct market failure

Gov spending

Aims of supply side policies

To increase incentives

To promote competition

To improve quality and skills of labour by increasing gov spending in education and healthcare

To improve infrastructure

Strengths of supply side policies

Reduce unemployment

Boost net trade

Improve in quality of life

Reduce average price levels

Weaknesses of supply side

Implementation costs

Time lags

Distribution of income worsens

Increased incentives

Increased incentives will increase the labour force

More goods and services produced

Incentives to joint work

Reducing taxes

Reducing benefits

Reducing or removing national minimum wage

Increase education and training - however quality of training might be poor

Improving infrastructure health and education - however there is an opportunity cost

Deregulation - makes it easier for firms to enter the market

Privitisation - selling companies to private sectors

Problem of incentives

Depends on size of reduction of tax

For high income earners, they pay less which means higher income inequality

Governments fall in revenue

More inequality