Fiscal, Monetary, Supply-side Policy (AS)

Fiscal policy definition:

This is the use of government spending and taxation to affect the level and growth of aggregate demand, output and jobs.

Aims of expansionary fiscal policy: (four)

• Boost growth
• Decrease unemployment (labour is a derived demand)
• Increase inflation (in theory but this is not really the government's job)
• Redistribute income

Aims of contractionary fiscal policy: (four)

• Decrease inflation (in theory but this is not really the government's job)
• Reduce budget deficit/national debt
• Redistribute income
• Reduce current account deficit (less sucking in of imports)

What parts of the AD equation could expansionary fiscal policy affect?

Consumption - more disposable income. Especially if a regressive tax is cut because these burden the poor more than they do the rich and the poor have a high marginal propensity to consume.
Investment - less corporation tax means more retained profits which can lead to more investment by firms.
Government spending

Drawbacks to expansionary fiscal policy: (Seven)

• Demand pull inflation
• Current account deficit
• Worsening of gov finances
• Crowding out effect
• X-inefficiency - governments don't have a profit motive so therefore government projects could be inefficient
• Ricardian equivalence - the idea that people know that the government can't afford the tax cut so instead of spending their money they save it to get ready for an inevitable tax increase
• Time lags - infrastructure projects can take a while and it can also take a while for people to spend their extra income from the tax cuts

Evaluation: what determines if expansionary fiscal policy has more positives than negatives or vice versa? (Nine points)

• Size of the output gap
• Size of the multiplier (the higher the multiplier the less government spending needed)
• Confidence (people might just save the tax cut)
• State of government finances
• Long run returns to the government (could mean debt now but in the long run it could be worth it)
• Laffer curve
• Automatic stabilisers (the stronger these are the less need for discretionary fiscal policy (fiscal policy on top of the automatic stabilisers))
• Crowding out vs crowding in
• Classical view of self correcting economy in a recession (wages fall which reduces unemployment and so on) - is expansionary fiscal policy needed?

Automatic stabilisers definition:

Automatic fiscal policy changes, that happen as an economy moves through the stages of the economic cycle, to influence GDP and counter the fluctuations of the cycle.

What are the two main automatic stabilisers?

• Progressive income tax system
• Welfare benefits (specifically unemployment benefits)

How do the automatic stabilisers work in a boom (in a recession it is just the opposite of this)? (4 steps)

• Income increase which pushes workers into higher tax bands - ART increases
• Slowing down consumption (C decreases)
• Unemployment is low so government spending on benefits decreases (G decreases)
  Link both of these to the AD equation.

Discretionary fiscal policy definition:

This is the government actively making a change to government spending or taxes.

Cyclical and structural budget deficit/surplus definitions:

Cyclical - budget deficit/surplus in a / due to a recession/boom.
Structural - budget deficit/surplus at full employment.

Benefits of a budget deficit: (Five)

• Higher growth, lower unemployment
• Benefits of increased government spending (long run returns)
• Redistribution of income
• Incentives of tax cuts (more immigration and entrepreneurship, which can increase LRAS)
• Crowding in - an increase in government spending will increase aggregate demand and firms will want to make the most of this

Drawbacks of a budget deficit: (six)

• Deterioration of government finances - this will cause lower credit ratings on government bonds so government will have to give higher coupons.
• Debt interest payments will increase which carry a large opportunity cost. This could deter foreign direct investment.
• Inflation as AD increases
• Current account deficit
• Crowding out
• X-inefficiency (there is no profit motive for the government)

Evaluation: what could cause the negatives to outweigh the positives (or vice versa), when deciding to increase the budget deficit? (six)

• The current state of government finances
• Short run vs long run impacts
• Stage of the economic cycle
• Specific policy used (increase in government spending or decrease in tax)
• Consumer/business confidence
• Automatic stabilisers (if the role of these is strong it decreases the need for discretionary fiscal policy)

Positives of a budget surplus: (five)

• Confidence in government finances - credit ratings should increase and so should foreign direct investment.
• Flexibility of fiscal policy
• Less crowding out / x-inefficiency
• Lower inflation and current account deficit
• Less debt interest payments

Drawbacks of a budget surplus: (Five)

• Demand side shock (government spending decrease and taxation increase)
• Long run returns of higher government spending and lower taxation ignored
• Disincentives due to increase taxes (less productivity)
• Greater risk of income inequality
• Micro and macro impacts of lower government spending (e.g. healthcare, education, public services)

Evaluation: what could cause the negatives to outweigh the positives (or vice versa), of having a budget surplus? (four)

• Need?
• Debt in comparison to GDP could this ratio get worse?
• Policy used (increased taxation or decreased government spending)
• Stage of economic cycle

Monetary policy definition:

Changes to interest rates and the money supply by the central bank in order to influence AD.

What can expansionary monetary policy help to achieve? (three)

• Increase inflation (central bank mandate)
• Increase growth
• Reduce unemployment

What can contractionary monetary policy help to achieve? (five)

• Reduce inflation (central bank mandate)
• Prevent asset/credit (borrowing) bubbles
• Reduce excess debt and increase saving
• Reduce current account deficit
• Discourage household/corporate debt

Ways expansionary monetary policy can affect the economy (transmission mechanism): (five)

• Credit card and interest rates decrease - consumption will increase
• Saving rates decrease - consumption will increase
• Variable mortgage rates decrease - consumption will increase
• Business loans rates decrease - investment will increase (this can also shift LRAS)
• Weaker exchange rate (hot money outflows) - (X-M) will increase

Drawbacks to expansionary monetary policy: (five)

• Demand pull inflation
• Current account deficit (maybe due to sucking in of imports)
• Liquidity trap/interest rates have a lower bound - i.e. people have already turned their illiquid assets (savings) into liquid assets (cash)
• Negative impact on savers
• Time lags

How long can the interest rate transmission mechanism take in the UK economy?

18 months to 2 years

Evaluation: what can cause expansionary monetary policy to have more negative effects than positive (or vice versa)? (five)

• Size of the output gap
• Consumer confidence
• Business confidence
• Banks willingness to pass on the interest rate cuts
• Size of the interest rate cut

Benefits of contractionary monetary policy: (seven)

• Decreased inflation (demand pull)
• Discourages debt
• More sustainable borrowing
• Encourage saving
• More affordable housing (increase in the cost of mortgages means less demand for housing)
• Reduces the current account deficit (less sucking in of imports)
• Flexibility for expansionary monetary policy

Drawbacks to contractionary monetary policy: (five)

• Lower growth
• Higher unemployment
• Impact on the indebted
• Reduce investment (higher cost of borrowing)
• Can worsen the current account deficit (hot money inflows)

Supply side policies definition:

Policies designed to increase the productive capacity of the economy, shifting LRAS to the right. If successful all four main macroeconomic objectives will improve.

What are the three main interventionist supply side policies?

• Government spending on education/training
• Government spending on infrastructure
• Subsidies to firms to promote investment

What are the seven main market based supply side policies?

Tax reform:

• Lower income tax - incentive for the inactive to work and incentive to work harder
• Lower corporation tax - more investment
  Labour market reform:
• Reduce benefits - may cause more of the inactive to work
• Reduce minimum wages and trade union power - lowers costs for businesses which will decrease long run costs and therefore improve productive efficiency in the economy Competition policy (increasing competition will help to increase productivity):
• Privatisation
• Deregulation
• Trade liberalisation

Cons/evaluation of supply side policies: (Six)

• No guarantee of success
• Cost (especially interventionist)
• Time lag (education)
• Negative impacts for workers and society (mostly from market based SSPs)
• Size of the output gap
• Need for targeted SSPs (e.g. infrastructure might be most needed)

What policy should be used to help fix cyclical unemployment?

Economic growth is needed to increase demand.

What policies could be used to fix real wage unemployment? (two) Evaluate.

• Reduce minimum wages
• Reduce strength of trade unions
  Evaluation - this will have a negative impact on workers and could increase income inequality.

What type of policies are needed to bring down the natural rate of unemployment (frictional + structural)?

Supply side policies

What are the interventionist and market based supply side policies that could be used to counter structural unemployment? (4 interventionist and 2 market based)

Interventionist:

• Spending on education/training
• Subsidies for in work training
• Spending on infrastructure (geographical immobility of labour)
• Grants for low cost housing (geographical immobility of labour)
  Market based:
• Reduce benefits
• Deregulate hiring/firing laws - allows firms to hire low skilled workers to train but then easily fire them if it doesn't work out

What are the interventionist and market based supply side policies that could be used to counter frictional unemployment? (three interventionist and one market based)

Interventionist:

• More and better resources for job centres
• Subsidies to private job agencies
• Spending on infrastructure - this will give people a large area to choose a job from which help them to find a job quicker Market based:
• Reduce benefits

What policies can be used to reduce demand pull inflation?

Contractionary monetary/fiscal (remember it is not really the government's job to control inflation though) policy.

Evaluation: what could be some negative consequences of trying to reduce demand pull inflation (using contractionary fiscal/monetary policy)? (five)

• Reduces AD
• Impact on the indebted (higher debt interest payments for consumers and firms)
• Stronger exchange rate could cause current account deficit
• Higher unemployment
• Impact on investment (could be harmful in the long run)

What policies could be used to counter cost push inflation? (two)

• Implement/reduce the inflation target - so workers will ask for wage rises at that rate and not any higher
• Reduce VAT/subsidies for firms - but government finances would worsen

What policies should be used to reduce long term inflation rates?

Supply side policies (shift LRAS outwards)

Draw the circular flow of income diagram.

Draw the economic cycle and label it.

Which other graph does the real wage unemployment graph look like?

A minimum price graph.
Here though the minimum price is the minimum wage (due to government intervention of trade unions), the demand and supply curves are the demand and supply of labour and the y-axis is wage not price.

Draw a labour supply and demand diagram showing the natural rate of unemployment:

Draw the Laffer curve and label the axis.

What are the 4 components of the balance of payments on the current account?

• Balance of trade in goods
• Balance of trade in services
• Net primary income (interest, profits, dividends and migrant remittances)
• Net secondary income (military aid, overseas aid)

What % of GDP was the UK's current account deficit in 2015?

The deficit in 2015 equated to 5.2% of GDP at current market prices.

What is a typical NRU?

4-5%